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Although financial arms races are not a new phenomenon, the increase in financial scale over the past 30 years has intensified these pressures. Haldane uses three examples, from the past, present and future respectively, to demonstrate this point.
First, he notes that performance measures in banking, such as returns on equity and executive compensation, rose dramatically in the pre-crisis period. As banks tried to keep up with their competitors by growing their balance sheets, a spiral in a pay and returns emerged. This resulted in a “high-leverage equilibrium” that “sowed the seeds of the financial crisis”.
Second, the technological revolution in financial markets has created a quest for speed in trading activities. Despite its individual benefits, Haldane argues that the emergence of high-frequency trading may have created uncertainties and externalities. He points to market dynamics during the so-called Flash Crash: these “Liquidity mirages and message traffic congestion are nibbling away at the common good of market stability”.
Third, investors’ pre-crisis quest for return has been replaced by a quest for safety. As a result, a large and rising fraction of global banks’ refinancing has taken place on secured terms. But Haldane argues that the quest for individual safety may generate system-wide instability: “at high levels of encumbrance, the financial system as a whole may even be riskier, as it is more susceptible to pro-cyclical swings in the underlying value of banks’ assets”.
Haldane suggests that these arms races – in return, speed, and safety – could have been forestalled. But to be effective, policy intervention would have needed to constrain behaviour across the financial system as a whole. In other words, “... policy needs to have a macro-prudential, as distinct from micro-prudential, perspective”.