Since the onset of the global financial crisis more than five years ago, policy-makers have had their heads firmly focused on the tarmac directly in front of them. The safety of what was immediately under foot trumped concerns over long-term direction. Quantitative easing, the defining policy innovation of the crisis, breathed fresh life into the very same housing and equity markets that led to the boom that ultimately led to the bust. It would be churlish, though, to be hard on policy-makers. When you are caught in a crisis, there is little time for long-term strategy.
At the annual IMF/World Bank “Spring Meetings” in Washington DC, the IMF will declare the recession over. In the advanced economies where the recovery has been hesitant and labour markets are still weak, the IMF now forecasts growth to reach 2.3%, up from 1.3% in 2013. In emerging market economies where signs of fragility appeared last May, growth is set to safely exceed 5.0% – world growth will be a smidgen below 5.0%. Critically, growth is broadening out. Europe and Japan are following the US upwards. The African continent is a repeat star performer, offsetting modest slowdowns in China and India.
Now is the moment for policy-makers to lift their gaze. To ensure we are not locked into a cycle that leads inevitably to the next crisis, they will need to jettison the prevailing model of finance. This is routinely said but seldom meant. When people talk of “radical reform”, what they often mean is more ethical behaviour from bankers, greater transparency and less reliance on the public purse. Many so-called radical proposals, forcing banks to issue bonds that convert to equity in times of trouble, or insisting that all instruments are on a public exchange, or requiring the same capital to be posted against the same instruments whoever holds them, actually further support the prevailing model of finance.
This model of finance did away with the moody credit officer of the local bank who approved a 10-year loan on the back of knowing the business and its managers, or the life insurance investment officer who bought and held on to property investments until their liabilities matured. In its stead was a world of super-securitization in which all risks could be stripped out of all assets and traded, and the prevailing prices used to value and hedge all assets and their risks. The circularity was ignored, and those brought up on CNBC, or more obscurely, the Arrow-Debreu economic models, considered this financialization to be progress. Anything that got in the way of trading liquidity was not.
The inconvenient truth is that at any one time the same asset can have different equally legitimate values. The best price I can obtain if I had to sell my house tomorrow is different than the best price I can obtain if I can sell over the course of the next 10 years. The former is the legitimate price if I need liquidity tomorrow, but it is not if I am holding the asset against a pension liability in 10 years’ time. Ignoring all other prices but today’s price in the valuing, managing and hedging of risks creates losses for consumers and risks for stability.
Long-term investors forced by regulators or prevailing practice to respond to daily shifts in market prices are denied earning the liquidity premium for their customers – the extra return on investment by committing funds for the long term. Moreover, a safer financial system is one where in times when there is a demand for liquidity, those short-term investors are able to sell assets to long-term investors. If all investors are forced to use the same price to value, trade and hedge assets, there are no opportunities for risk-absorbing transfers.
The financial world is a safer place when different types of savers and investors are able to value assets differently and trade. One simple yet transformative reform is to switch from the mark-to-market approach in valuation, risk management and capital adequacy or solvency to a concept I introduced a few years ago.
Under mark-to-funding, assets can be priced on the basis that the time available to sell the assets is as long as the liability that backs the asset. In other words, a portfolio of equities purchased to provide a pension in 10 years’ time should be valued on the basis of what kind of pension it can purchase in 10 years’ time and not on the basis of yesterday’s price movement. Mark-to-funding is no let off. It would apply a strict discipline to banks and others with short-term funding, while supporting long-term investors investing for the long-term. This one step would make the financial system more fit for purpose, less leveraged to the economic cycle and less like a traders’ playground.
Avinash Persaud is Founder and Chairman of Intelligence Capital and Member of the World Economic Forum’s Global Agenda Council on the International Monetary System.
Image: A trader looks up at a chart on his computer screen while working on the floor of the New York Stock Exchange. REUTERS/Lucas Jackson