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diversify away from non-core banking activities the moral hazard that is knownto promote excessive risk-taking in traditional banking would be extended tothese other activities, in particular securities markets. The question then waswhether ‘the mixing of banking and securities business can be regulated in such away as to avoid the danger of a catastrophic destabilisation of financial markets’3.
After considering all the regulatory options, I concluded that there was no solution:‘Allowing banks to engage in risky non-bank activities could either destabilisethe financial system by triggering a wave of contagious bank failures – oralternatively impose potentially enormous costs on tax payers by obliginggovernments or their agencies to undertake open-ended support operations.’4The prevailing view amongst finance academics at the time, as reflected in acritical review of my book in the Journal of Finance, was that financial structure
was largely irrelevant to the question of systemic stability.5 According to the conventional
wisdom we had learned from the 1929/33 crash, a monetary contraction
such as occurred then could be neutralised by injecting reserves into the
banking system and a flight to quality, because it merely redistributes bankreserves, ‘is unlikely to be a source of systemic risk’.6 This widely held view of thebehaviour of financial markets turns out to have been entirely misguided. As wehave witnessed in recent months, a major shock arising from publicised losses onbanks’ securities holdings can have a domino effect on financial institutions,leading ultimately to a seizure in credit markets which central bankers, on theirown, are powerless to unblock. Only drastic government intervention – guarantees
for money market funds, guarantees for interbank lending, emergency depositinsurance cover, lending directly to the commercial paper market, and partlynationalising the banking industry – has prevented a full repetition of the 1929/33financial meltdown.
116 The First Global Financial Crisis of the 21st Century Part II
2 Richard Dale, International Banking Deregulation: The Great Banking Experiment, Wiley-Blackwell 1993.
3 Ibid, p.2
4 Ibid, p.43
5 Book review by Richard Herring, Journal of Finance, September 1993, pp. 1553–1556.
6 Ibid, p. 1554.
In addition to underrating the importance of financial market structure,
finance academics have also largely neglected the well-documented boom/bustcharacteristic of asset and credit markets. In my recent book on the South SeaBubble, I analysed the behaviour of South Sea stock prices and concluded that,even when judged against the valuation techniques available at the time, there is
overwhelming evidence that the South Sea boom represented an irrational bubble.7My central thesis was that, taken together with other more recent boom/bustepisodes, the events of 1720 lend force to the argument that national authoritiesmust intervene to head off unsustainable financial market booms. I was also criticalof revisionist histories of financial upheavals such as the South Sea Bubblethat have tended to stress the rationality of investors and downplay the idea thatfinancial markets are inherently unstable and prone to bouts of euphoria and
panic.8
What we have witnessed in recent months is not only the fracturing of the
world’s financial system but the discrediting of an academic discipline. There aresome 4000 university finance professors worl