It’s a wind-up

As the credit crisis has unfolded, several vicious circle processes have come to light which have contributed to its magnitude and persistence. Such positive feedback loops – which in this case are sometimes wrongly called negative feedback loops because they reinforce the credit crisis – act to increase the response of a system to a change in an input variable. On the assumption that these mechanisms are intolerable, analysts of the credit crisis have suggested various financial system reforms to eradicate them. RebelEconomist, however, questions whether such positive feedback loops really are a major problem, and considers that some of the proposals to get rid of them might create their own perverse effects.

One such positive feedback mechanism that has been much discussed recently is bank capital adequacy regulation. The existing fixed capital ratio rule has the effect of amplifying the business cycle, because during a period of elevated credit losses like the present, banks may prefer to contract lending and sell existing assets to reduce any resulting capital shortfall rather than sell additional shares at depressed prices or cut dividends to raise more capital. To the extent that selling and buying less assets reduces asset values in general, the asset side of the banks’ balance sheets contracts further, and forces further asset sales, and so on in a vicious circle. In order to reduce this inherent pro-cyclicality, Goodhart and Persaud propose that a bank’s capital requirement should depend on its recent asset growth, so that bank capital coverage automatically rises during credit booms to restrain the expansion, and falls in busts. The trouble is, who would lend money to a bank that was being allowed to run down its capital cushion against losses at a time of financial turmoil? You might as well propose that gravity be reduced at the bottom of hills. One lesson that should have been learned from the credit crisis is that, if there is the slightest doubt about a bank’s solvency during a time of stress, it will be shunned by lenders. Unless the scheme introduces counter-cyclicality by forcing banks to hold excess capital at all times except the very worst, which would certainly be strongly resisted by the banks and may well be inefficient, it might even exacerbate a credit crisis.

Another positive feedback mechanism is the requirement for financial businesses to report realistic market, or “fair”, values for a large proportion of the assets they hold (the alternative being to value the assets at their historic cost when acquired). This requirement (eg as specified in FASB statements 157 and 159 in the US) has been applied increasingly extensively to financial businesses. Since fair market valuation reveals the effect of falling asset values on firms’ solvency, it raises their cost of funding following such losses and so exacerbates their problems. In this case, proposed remedies include restricting the scope of fair value accounting to assets that are intended to be held for a short period only, or at least suspending further introduction of fair value accounting until the credit crisis subsides. No doubt a firm in difficulty would be grateful for the opportunity to try to trade its way out of trouble with money owed to its creditors, under the cover of accounts that do not reflect creditors’ exposure to a potential default, but such obfuscation could be expected to discourage future commitments and raise the cost of new credit. In fact, economic theory suggests that, in the absence of full disclosure, creditors might well assume that the danger is worse that it really is. Apart from providing some short-term relief at the expense of already committed creditors, abandoning fair value accounts might also exacerbate a credit crisis.

Perhaps the concern about positive feedback mechanisms in the financial system is misplaced. Positive feedback is quite common in nature, such as the amplifying effect of sea ice on global temperature or the cascade of neutrons in nuclear fission. No doubt, as discussed, many of the positive feedback mechanisms in the financial system exist for good reason. Provided that a feedback process is convergent, or is interrupted or counteracted by some other process before it progresses too far, it is not necessarily a problem. It can simply be seen as playing a role in determining the path and amplitude of the system’s dynamic response to changes in input variables. What really matters is that the influence of any such feedback mechanisms is taken into account when predicting the response of the system to shocks. In short, a reasonable answer to coping with financial system positive feedback mechanisms like capital adequacy requirements or fair value accounting is for firms to allow for them by either further reducing their exposure to risk or building in more protection.