Mr. King's comments are very important as they demonstrate just why monetary policy and bank supervision should never be combined in the same organization.
Mr. King would have us believe that if the central bankers had managed interest rate policies differently the opaque areas of the financial system like banks and structured finance securities would not have collapsed.
Sorry, but even the Financial Crisis Inquiry Commission was able to identify the simple fact that interbank lending markets froze not because of macro economic policies but for the simple reason that lending banks could not tell which borrowing banks were solvent and which were not.
The interbank lending market has not unfrozen because lending banks still cannot answer this solvency question.
Mr. King is right that economic policies contributed, but the necessary condition for the crisis to occur was the financial regulators let huge areas of the financial system become opaque. This meant that market participants could not assess the risks of or value securities in these areas.
As a result, when central banks kept interest rates too low, it was like pouring gasoline on a fire, it led to over investment in the opaque areas where investors were chasing yield and simply blindly betting.
Your humble blogger has previously observed and Mr. King's comments confirm that macro economists do not make good bank supervisors. By training and temperament, they like to look at the big picture. Good bank supervision is all about looking at the details.
If you look at the details, you see that opacity was the basis for bank profitability. It also allowed bankers to engage in bad behavior by hiding this behavior. As Yves Smith said, 'no one was compensated on Wall Street for creating low margin, transparent products'.
If you look at the details, you see that the financial system stopped functioning every place there was opacity.
If you look at the details, you see that it was opacity that made assessing the risk or value of banks and structured finance securities impossible.
If you look at the details, you see the "run on the repo" was the result of the simple fact that opacity made it impossible to assess the risk or solvency of the borrower or, in the case of structured finance securities, the value of the security being pledged (the financial crisis started when BNP Paribas announced it could not value subprime mortgage backed securities). The run was nothing more than simple recognition of the fact that you don't lend money if you don't think you will get it back.
If you look at the details, you see that opacity prevented market participants from exerting discipline on the banks to restrain their risk taking.
If you look at the details, you see that bank regulators are the only ones with transparency into banks and they are dependent on each bank to explain what it is doing. They cannot ask experts like the bank competitors for analytical help because opacity means these experts don't have all the useful, relevant information.
If you look at the details, you see that banks regulators do not restrain a bank's risk taking. This is the result of the simple fact that regulators are not in the business of approving or disapproving any position a bank takes. This is the market's capital allocation function. Rather, bank regulators try to estimate the potential loss from a position and try to ensure there is adequate book capital to absorb the loss.
If you look at the details, you find that transparency is the source of trust and confidence in the financial system. It is only when market participants have all the useful, relevant information and can independently assess the risk of an investment is there trust and confidence. This trust and confidence comes because the market participants trust their own analysis.
If you look at the details, leading up to the financial crisis, market participants trusted others for help in assessing the risk in the opaque areas of the financial system. Market participants trusted the analysis of the financial regulators when they said that the risk of the banks was greatly reduced and the rating agencies when they said structured finance securities were rated AAA. When the financial crisis hit, market participants rediscovered the importance of not trusting others and having transparency so they can do their own analysis.
If you look at the details, even if there had been perfectly co-ordinated macro economic policy around the world, there was and still is so much opacity in the system that a crisis was inevitable.
Speaking at the Government’s Global Investment Conference in London,Sir Mervyn gave the clearest signal yet that as head of Britain’s central bank he is partly to blame for failing to act before the crisis took hold in 2008.
He said it was “false” to suggest that the crisis was caused by the bad behaviour of bankers.
“Of course there was bad behaviour.
But this was a crisis which emanated from major mistakes in macro economic policy around the world, and fundamentally the inability to successfully co-ordinate macro economic policy so that globally you wouldn’t get the imbalances, the capital flows, that created the difficulties in the banking system.
“We saw this going into the crisis, we kept meeting at the IMF, but we did nothing to solve it collectively, and I don’t think that this was a problem that could have been solved individually.”
Sir Mervyn said the global crisis will require a collective response....
The governor said that global banking had taken a “series of wrong turns”, but that the reform agenda in the UK would create a more stable framework for the future. He said the measures recommended in the Vickers report should be implemented, and “then [we can] come back and see if we need to go further.”