Re Regulating Finance

This is a very useful discussion/policy paper from Pierre Habbard of the Trade Union Advisory Committee to the OECD.

Executive summary

1. The latest phase of the financial crisis that broke out in the summer 2007 was marked by a dramatic turn in mid-September with the collapse of Wall Street, US insurance group AIG, and the subsequent asset destruction process that hit the OECD banking sector front on. Stock market indices have fallen to pre-2000 levels. According to the latest OECD projections, it is now certain that the US and Europe will fall into recession in 2009, while the Japanese and Korean economies will stagnate. The ILO predicts that unemployment will rise by an estimated 20 million people, the number of working poor living on less than a dollar a day by 40 million and those on 2 dollars a day by more than 100 million. The fall in world equity indices will inevitably put pressure on the funding of pension funds, notably in the US, Canada, the UK, the Netherlands and the Nordic countries, as will the expected implosion of the alternative industry in 2009 – hedge funds and private equity – in which pension funds have been investing heavily over the past five years.

2. The current economic crisis began in the US as a conjunction of a housing crisis, a credit market crisis and, increasingly, an employment crisis. The crisis has revealed the unsustainability of the model of growth that has prevailed across OECD economies in the past decade, particularly in the US: a model that was based not on the real economy with wage increases reflecting productivity growth, but on debt-financed consumption and investment and the excessive leveraging of the private sector.

3. Neither governments nor the central banks foresaw the bubble that grew in the US mortgage market up to 2006, which imploded in the first quarter of 2007. What accelerated the crisis was the complex and lightly regulated structured finance industry that securitised the credit risks of the US mortgage market. Coupled with “pro-cyclical” accounting rules and rigid prudential rules, the credit crunch that followed created a self-perpetuating, asset depressing process in the banking sector.

4. Regulators and governments were content to let the structured finance industry develop outside their jurisdiction. Structured finance is founded on the belief that spreading risk ultimately mitigates risk, reduces the cost of capital and thereby enhances economic growth. It created the illusion of low risk, low-cost capital. Being managed by “sophisticated” investors, regulators believed that the business did not need regulation. As it happened, however, this created major complications for regulators. Light regulatory approaches helped to blur the boundaries between regulated and un-regulated financial services. Off-balance sheet operations allowed regulated banks and insurance groups to practice double accounting.

5. The current crisis reveals the threat that the “shareholder value” model of corporate governance can pose to market integrity in much the same way as the Enron episode did in 2001-2002. The banks that were hit by the crisis were ruled by “imperial CEOs” and did not have proper risk management procedures in place. Departing directors and traders have benefited from grotesquely large compensation packages and golden parachutes. The money that was wasted in generous dividends and share buybacks in the past 2003-2006 growth cycle, is now badly needed as banks search for fresh money to recapitalise their balance sheets.

6. For months, banks have been struggling to clean up their bad assets by writing down the value of their holdings and have tried to raise capital to maintain acceptable prudential ratios. International institutions, including the OECD, expected market “self-correction” to resolve the crisis. It did not, however, work that way. The only way out was to use public money. Since 15 September 2008, OECD governments and financial authorities have introduced numerous initiatives to help restore solvency in the banking sector. These initiatives have highlighted the weakness in international capacity to manage such a large scale financial catastrophe. Governments have appeared behind the curve at every step of the development of the crisis.  In the immediate aftermath of the introduction of urgent measures, there will be a requirement for political-level international cooperation and dialogue to put content into the quid pro quo for bailing out the financial system. Re-regulation should address the flaws in the global financial systems, which have been exposed by the current crisis:

*    An unsustainable model of growth, fuelling wage compression, predatory lending,  debt-financed consumption and the transfer of market risks on to workers (pensions, housing);

*    An un-controlled ‘structured finance’ industry in which credit risks were not spread but hidden: a system that lacked regulation, was riddled with conflicts of interests and, when coupled with rigid prudential and accounting rules, created a self-perpetuating feeding asset depressing process;

*    Widespread institutionalised regulatory arbitrage between jurisdictions and within financial institutions which has helped to blur the lines between regulated and shadow banking, letting financial groups practice double accounting by using off-balance sheet operations and encouraging irresponsible risk-taking and leverage investment strategies;

*    Corporate short-termism and “shareholder value” governance undermining market integrity and stakeholders’ long term interests. The crisis has exposed weak risk management by ineffective Boards of Directors and turned the spotlight on the money that has been wasted in the past years in grotesquely large executive compensations, dividend proceeds and share buy-back programmes.

7. At the outset, any discussion on financial regulation should begin with defining the public function of financial services, which is to serve the real economy. Financial regulation is commonly associated with three objectives: (i) to maintain financial stability by ensuring solvency of market participants, (ii) to protect investors against failures and fraud, and (iii) to ensure “efficient and effective” financial markets. Any discussion on re-regulation also needs to identify the exact underlying objective of “effectiveness” in financial markets: is the target economic growth in absolute terms or should it be a more qualitative understanding of growth combined with a fair distribution of wealth within society?

8. Following on from the Global Unions’ “Washington Declaration” submitted to the G20 Summit, held on 15 November 2008, this paper identifies some issues and questions designed to initiate a trade union discussion on the re-regulation of financial markets and the future shape that this should take. The discussion of such a road map needs, however, to be placed within the broader context of the rethinking of economic policy and growth models. The Washington Declaration included the following demands: in the short term “initiate a major recovery plan” and in the medium term “establish a new structure of economic governance for the global economy” and “combat the explosion of inequality in income distribution that lies behind this crisis”. The discussion issues are grouped under three broad objectives:

*    Strengthening financial safeguards and international cooperation (prudential regulation, public accountability of central banks, conditions for capital market opening, offshore financial centres (OFCs), staffing of public administration);

*    Diversifying finance and protecting social development goals (the rights of households against predatory lending, community-based financial services and pension regulation, international taxation);

*    Spreading responsibility throughout the investment chain (credit risk transfers and credit rating agencies, private investment funds and conglomerates, executive compensation, corporate short-termism).


  • “Neither governments nor the central banks foresaw the bubble that grew in the US mortgage market up to 2006, which imploded in the first quarter of 2007.”

    It’s hard to believe they didn’t see it. More like they chose to ignore it.

  • Harvey Cardwell

    The efforts of Representative Collin Peterson to ban naked credit default swaps is a good first step.

    Naked credit default swaps (where the buyer has no underlying insurable risk) is no more than a form of bucketing – a practice outlawed in the early 1900’s.

    Moreover, naked default swaps provide a motivational incentive for buyers to attempt to intervene in (i.e., fix) the market in the underlying security. We outlaw markets in such things as “terrorism futures” for the same logical reasoning – we do not wish to provide anyone positive incentive to intervene in a market where such incentive is only realized when others, and not themselves, suffer a loss.

    (I’d like to be consistent, but I’m still deliberating on naked stock options.)

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