Markets as regulators: Who's better at spotting future financial problems: investors or regulators? That's the question at the heart of the debate gripping policymakers. The pre-crisis orthodoxy that markets tend to get it mostly right has been rejected. In its place is a consensus that financial regulators should restrain - and occasionally even oppose — exuberant investors. But for all the flaws, markets can still offer important warning signs.
Just a few years ago, the dominant belief among financial policymakers was that markets were the best at judging risk. Banks' own computer models would decide how much capital they needed to hold. Rational, profit-seeking investors would iron out valuation anomalies for even the most complex instruments. The role of regulators was to ensure a level playing field, but otherwise stay out of the way. Blind faith in self-correcting markets proved misguided.
As Adair Turner, chairman of Britain’s Financial Services Authority, recently pointed out, even in early 2007 — just a few months before disaster struck — the price of banks’ credit default swaps offered little clue of the coming catastrophe. Bold new scepticism has seeped into the regulatory mood. It explains why banks are being forced to hold higher levels of capital. It is also the guiding philosophy behind bubble-pricking macro-prudential bodies that have been set up in the US and Britain.
However, the change of course is based on an unspoken assumption: that, given the right tools, regulators would have done a better job at handling the crisis. Most recent financial reform is based on assumptions that regulators can monitor banks more effectively, design systems that are better able to cope with failure, and see around corners to spot future risks. The danger is the previous false orthodoxy is replaced with a similarly strong — but equally ineffective — anti-market consensus. To ignore the warning signals that markets provide would be a mistake.