There are no simple solutions to the complex problems facing credit markets without stunting the financial sector, warns Moody’s Investors Service in a new report.

The roots of the current credit crisis are extremely deep and quite strongly entrenched, says Moody’s, adding, given that the global financial system has become exponentially more complex in recent years, it is unlikely that simple solutions can be found to address these fundamental issues without materially reducing financial development and growth and the overall profitability of the financial sector.

“Since the onset of the current credit turmoil, there has been considerable soul-searching to understand exactly what triggered it, including an assessment of whether our current financial system is less resilient because of increased disintermediation,” explains Pierre Cailleteau, Moody’s chief international economist and author of the report. In particular, there is a question as to whether banks’ new business models, whereby they originate and redistribute loans, has resulted in unchecked risk-taking, liquidity risk and untenably large off-balance sheet liabilities.

Moody’s says that incentive structures in the financial industry appear to be flawed in some respects, resulting in a lack of “biodiversity” in the financial ecosystem as well as excessive risk-taking. However, it sees no reasonable likelihood that such flaws will be eliminated.

It also says that any system of financial regulation that promotes growth necessarily accepts a risk of a meltdown. “Although there might be ways to almost eradicate the risk of crises, policymakers have implicitly preferred the option of accepting the frequent failure and occasional crises that come with financial innovation because that course is, ultimately, growth-maximising. This can be viewed as a ‘Faustian pact’ that policymakers have made with the financial industry,” says Cailleteau.

Another problem is the difficulty of measuring risk over time: the complex interaction between credit risk and the economic cycle has proved challenging for risk managers and rating agencies alike. “As financial innovation has progressed, the traceability of risk has declined — perhaps forever. This raises two issues. First, greater capital buffers will be needed or required by counterparties and regulators. Second, not just more, but more intelligible information is needed,” Cailleteau observes.

Other roots of the crisis explored by Moody’s report include intellectual confusion over fundamental concepts such as liquidity, the absence of a satisfactory valuation paradigm and the paradoxical contrast between the sheer complexity of the global financial system and the precision of financial reporting.

“A key question is whether, beyond the current episode, these root causes of financial disorder can be addressed in a way that either eliminates or at least minimises the risk of recurrent turmoil. Moody’s believes that, as the global financial system has become exponentially more complex in recent years, it has spawned problems that defy simple solutions for maintaining financial development and growth and the overall profitability of the financial sector. Although another model is conceptually possible, such as one based on contra-cyclical devices and enhanced shock absorbers, great care must be taken to avoid the lethal risk that an increase in regulation poses to the financial ecosystem, namely reducing ‘biodiversity’,” Cailleteau explains.