Global Financial Crisis: Complexity, Dilemmas and Regulatory Failures
Department of Social and Politial Studies University of Milan Milano, Italy
Burns, Tom R.
Sociology University of Uppsala Uppsala, Sweden
Drawing on our earlier works, we show the ways in which institutional features of the banking and financial systems - relating to credit-formation and risk-taking - lead to overexpansion and ultimately systemic failures. The paper identifies several key factors explaining the regulatory and systemic failures:
(1) Technical Innovations. Commercical and investments banks (in Europe, the USA, and much of the world) along with hedge funds, insurance companies, and other financial institutions - in the pursuit of substantial gains, including projects of pure speculation - develop and/or adopt new ways to increase credit-creation and credit-utilization, in many instances beyond public and private regulation. Such "financial engineering" includes new instruments for spreading risk, which lower the costs of borrowing and enables still more credit-creation and credit-utilization.
(2) Risk-taking and Risky System Expansion. Long periods of successful "wealth" expansion also tend to relax public and private regulatory standards, and facilitate the emergence of informal operative norms and practices which minimize precautionary behavior and increase risky credit-creation and distribution. All of this helps drive the (increasingly risky) expansion of "wealth-creation" systems.
(3) Complexity and Regulatory Failure. The multiplication of diverse instruments makes for high complexity, limited overview and limited susceptibility to modelling and analysis. (even established measurements and indicators of system performance and vulnerability prove inadequate or inappropriate, e.g., failing to effectively measure growing risk-taking and the risks of system failures).
Uncertain Limits, System Shift. When the credit-expansion and speculative bubble(s) ultimately burst (as they must), there is a dramatic flip-flop leading, among other things, to a general loss of confidence and trust in the system and to rapidly spreading strategies of high precautionary judgment and risk-aversion. These "new shifting norms" of behavior mutually interact in a downward spiral with radical contraction of credit and financial markets. Such developments spill over to the "real economy". New principles and institutional arrangements - as well as leading indicators - for regulating credit and financial market are proposed in the paper based on our socio-economic analysis. Also, the analysis points to immediate ways to restore trust and confidence in banking and financial systems and their regulation.