During the Davos World Economic Forum in January 2003, to which I was invited as a speaker, one of the main topics of discussion dealt with re-establishing confidence in the business world. The current crisis in financial markets, which is a crisis of confidence in the banking sector in general, is again pushing this issue to the forefront.
Confidence is the most important form of social capital because it enables a multitude of transaction costs within a society to be reduced significantly. Confidence is also a form of private capital because a business will benefit from its partners’ confidence. But confidence created privately in this way has positive impacts on confidence toward all businesses.
This social effect is sufficiently great for public authorities to have a special responsibility in overseeing the development and maintenance of this capital of confidence. It is essential for an appropriate set of regulations to give it a framework and promote its development. The values of integrity will be all the more present and prevalent if the regulations favouring them are effective and rigorous.
Four problems to deal with
First, the manipulation and even the falsification of information sent out by organizations, especially in terms of risk measurement, is an initial pernicious factor that destroys social capital. A second problem arises from political intervention and regulators’ complacency toward regulated businesses, the cases of Fannie Mae and Freddie Mac being the most notorious. A third area comes from flaws in performance incentive mechanisms that too often lead to ill-advised risk-taking. In the context of the current crisis, these three factors fill the front rows. Inflexible application of the mark-to-market accounting rule, in a context where loss of confidence is causing the disappearance of the markets relevant to such evaluation, completes the picture.
To get out of the current slump, there is a need to loosen the mark-to-market accounting rule to take account of the value of asset-generated financial flows, for example, mortgage payments. In the current mood of fear, which is as irrational as it is widespread, mark-to-market in mortgages becomes disconnected from the value of the payments that borrowers, in a very large majority (94%), are continuing to make. There is also a need to favour performance incentive mechanisms that truly take account of the risks incurred. Finally, it is necessary to tighten the release of information on risks and to ensure the independence of regulators. Doing this requires making greater use of private regulatory bodies that are sheltered from political intervention.
* The French version of this article was published in the Journal de Montréal.
Marcel Boyer is Vice President and Chief Economist of the Montreal Economic Institute.