The financial market

The need for more effective regulation of the financial market

The current crisis has made it abundantly clear that more finance and more financial products are not always better and the pressing need is to increase the clout and responsibilities of financial regulators, says UN development agency UNCTAD.

Kanaga Raja

MORE effective regulation and supervision of the financial market is indispensable to prevent a repeat of the current global financial and economic crisis, but equally important is a reform of the international monetary and financial system to reduce the scope for gains from currency speculation and avoid large trade imbalances.

This view has been voiced by the United Nations Conference on Trade and Development (UNCTAD) in its recently released Trade and Development Report 2009.

UNCTAD presents what it calls an innovative approach to the reform of the international monetary and financial system, which stresses the stability of real exchange rates. It suggests that countries adopt a system of managed flexible exchange rates that would target a real exchange rate that is consistent with a sustainable current-account position.

To weed out financial instruments with no social returns and to prevent future, similar financial crises requires more effective regulation of financial market activity, UNCTAD says, adding that such regulatory reform should be coordinated internationally and should be part of a profound overhaul of the entire international monetary and financial system.

The case for regulation

According to the report, the most serious financial crisis since the Great Depression, the de facto nationalisation of a large segment of the United States financial system, and the deepest global recession since the Second World War are now casting doubts on assumptions made by a number of economists on the functioning of contemporary finance.

Many economists and policymakers believed that securitisation and the 'originate and distribute' model would increase the resilience of the banking system, that credit default swaps would provide useful hedging opportunities by allocating risk to those that were better equipped to take it, and that technological innovation would increase the efficiency and stability of the financial system.

A major cause of the financial crisis was the build-up of excessive risk in the financial system over many years, made possible by new financial instruments that obscured debtor-creditor relations. Many new financial instruments that were praised as enhancing financial efficiency were de-linked from income generation in the real sector of the economy.

UNCTAD says that this could largely have been prevented if policymakers had been less ideological and more pragmatic. Policymakers should have been wary of an industry that constantly aims at generating double-digit returns in an economy that is growing at a much slower rate, especially if that industry needs to be bailed out every decade or so.

Inappropriate risk assessment, based on inadequate models, has resulted in lax financial control and encouraged risky financial practices. This suggests that a greater degree of prudence and supervision is necessary, including more regulation - not deregulation as in the past.

The case for reviewing the system of financial governance now seems obvious, and has been made by many leading economists, says the report.

It is therefore surprising that the G20, the intergovernmental forum mandated to promote constructive discussion between industrial and emerging-market economies on key issues related to global economic stability, has paid very little attention so far to the necessary reforms of the financial system. Its recent communiques highlight several problems with tax havens and offshore centres (which played a minor role, if any, in the build-up of the current crisis), but provide no proposals on how to redesign financial regulation.

The crisis has made it abundantly clear that more finance and more financial products are not always better, and a more sophisticated financial system does not necessarily make a greater contribution to social welfare.

On the contrary, notes the report, several innovative financial products have had negative social returns. Thus, in order to reap the potential benefits of financial innovation, it is necessary to increase the clout and responsibilities of financial regulators.

A standard assumption behind most regulatory systems is that all financial products can potentially increase social welfare. The only problem is that some products may increase risk and reduce transparency. If these issues could be addressed, the argument goes, more financial innovation would always be beneficial from the social point of view.

'This assumption is wrong,' the report stresses. Some financial instruments can generate high private returns but have no social utility whatsoever. They are purely gambling instruments that increase risk without providing any real benefit to society. They may be transactionally and informationally efficient, but they are not functionally efficient.

While policymakers should not prevent or hinder financial innovation as a matter of principle, they should be aware that some types of financial instruments are created with the sole objective of eluding regulation or increasing leverage.

Financial regulation should therefore aim at avoiding the proliferation of such instruments. A positive step in this direction could be achieved with the creation of a financial products safety commission which would evaluate whether new financial products could be traded or held by regulated financial institutions.

Of course, says the report, tighter regulations will have a negative effect on financial innovation (regulations would not be effective if they did not), and in some cases may prevent the adoption of useful financial instruments. 'But there is almost no evidence that financial innovation has a positive impact on economic development, and there is substantial evidence that financial innovation is often motivated by the desire to evade taxes or elude regulation.'

Avoiding regulatory arbitrage

Poorly designed regulation can backfire and lead to regulatory arbitrage. This is what happened with banking regulation. Usually, banks take more risk by increasing their leverage, and modern prudential regulation revolves around the Basel Accords which require banks with an international presence to hold a first-tier capital amount equal to 8% of risk-weighted assets.

Over the past 25 years, the report points out, the 10 largest United States banks have substantially decreased their leverage, going from a non-risk-adjusted first-tier capital ratio of approximately 4.5% (which corresponds to a leverage of 22) to a non-risk-adjusted first-tier capital ratio of approximately 8% (which corresponds to a leverage of 12.5).

Since capital is costly, bank managers have tried to circumvent regulation by either hiding risk or moving some leverage outside their bank. This shifting of leverage has created a 'shadow banking system'. At its peak, the United States shadow banking system held assets of approximately $16.15 trillion, about $4 trillion more than regulated deposit-taking banks.

In order to avoid regulatory arbitrage, the report stresses that banks and the capital market need to be regulated jointly, and financial institutions should be supervised on the basis of fully consolidated balance sheets. All markets and providers of financial products should be overseen on the basis of the risk they produce. If an investment bank issues insurance contracts like credit default swaps, this activity should be subject to the same regulation that applies to insurance companies. If an insurance company is involved in maturity transformation, it should be regulated like a bank.

According to the report, the 'originate and distribute' model - a process in which banks originate loans then sell them, packaged into different types of securities, to a wide range of investors - was supposed to increase the resilience of the financial system and isolate banks from costly defaults.

However, securitisation did not deliver as expected for several reasons. First, banks entered the game because a regulatory loophole allowed them to buy structured products and increase leverage through lightly regulated conduits. Second, as banks are likely to be more careful in evaluating risk when they plan to keep a loan on their books, securitisation led to the deterioration of credit quality. Third, securitisation increased the opaqueness of the financial system. Fourth, most investors in the collateralised debt obligations (CDOs) market were of the 'buy-and-hold' type. This resulted in low market turnover and no price discovery.

Regulatory arbitrage not only applies to institutions within a jurisdiction, but also extends across jurisdictions. It is therefore necessary to add an international dimension to financial regulation, says the report. As a minimum, regulators based in different countries should communicate and share information. At this stage, it is impossible to implement a global early warning system because there are no data for either cross-border exposures among banks or derivative products.

Regulators should work together towards developing joint systems for the evaluation of cross-border systemic risk, and share information on liquidity and currency mismatches in the various national markets.

But international cooperation needs to go beyond sharing information, the report underscores. It needs to focus on regulatory standards, and ensuring that financial regulation by countries avoids a race to the bottom. At present, the responsibility for guaranteeing international financial stability rests with the IMF, the Basel Committee on Banking Supervision (BCBS), and the Financial Stability Forum (FSF, recently renamed Financial Stability Board). However, the problem is that these institutions not only have similar views but they also lack representation.

Distorted incentives

In many countries, financial regulation (and deregulation) rests on the idea that bank managers would not do anything that would prejudice the long-term value of their firms. With the benefit of hindsight, it is now clear that this idea is fundamentally flawed, says the report. Large corporations are composed of individuals who always respond to their own private incentives, and those who are in charge of risk control are subject to the same types of incentives that dictate the behaviour of investment officers. In most cases, risk officers who are too persistent in ringing bells and blowing whistles are either isolated or fired.

Noting that the list of distorted incentives at the root of the current crisis is long, the report points to executive remuneration in the financial industry and the regulatory role of credit rating agencies as being paramount. Remuneration in the financial industry depends on beating some benchmark while not taking additional risk. This risk-adjusted excess return is usually referred to as Jensen's alpha. In principle, rewarding alpha returns may seem a correct way to assign bonuses. In practice, though, it is very difficult to evaluate an asset manager's ability to generate alpha returns.

Since such returns are difficult to obtain (not everybody can be above average), asset managers may try to generate fake alpha returns by adopting a strategy that leads to excessive returns in most states of the world but hides an enormous tail risk, that is, a very small probability of extremely large negative returns, says the report.

While there is no regulatory framework that can assure a 100% success in limiting incentives to take excessive tail risk, greater transparency, including full disclosure of compensation schemes that may then be used to measure incentive alignment, and the design of remuneration structures that focus on longer-term performance - and not just on the returns of a single year - may be a step in the right direction, the report recommends.

Credit rating agencies should improve information flows in financial markets and increase the overall efficiency of those markets. There are, however, problems arising from their peculiar role in modern finance. On the one hand, they are private profit-seeking companies (the 'agency' part of their name is misleading). On the other hand, their decisions and activities are at the centre of the prudential regulatory system.

Credit rating agencies do not take legal responsibility for their rating decisions on the ground that their activities are similar to those of financial journalists and are thus protected by freedom-of-speech legislation. 'This seems a paradoxical argument because their regulatory role gives them a virtual monopoly, which was officially sanctioned by according them the status of nationally recognised statistical rating organisations in the United States in the mid-1970s and by the Basel Accords.


[In a recent decision, on 2 September, US Federal District Judge Shira Scheindlin in New York rejected arguments by Moody's and McGraw-Hill, owner of Standard & Poor's, that investors cannot sue over deceptive ratings of private-placement notes because those opinions are protected by free-speech rights. The judge's decision, according to a US hedge fund manager David Einhorn (cited by Bloomberg), forces S&P, Moody's and the Morgan Stanley bank, which was also sued, to respond to fraud charges in a class-action suit filed by Abu Dhabi Commercial Bank (based in the United Arab Emirates) and the US Washington State's King's county. The investors are suing the two rating agencies for assigning top rating for subprime mortgage-based securities, and Morgan Stanley for marketing them.]

The present financial crisis is a developed-country crisis. But, says the UNCTAD report, although developing countries have been mostly innocent bystanders, they can derive several lessons from the current crisis for their own financial policies. The current crisis shows that more sophisticated financial systems require more, and not less, regulation.

According to the report, in the absence of a complete overhaul of the global financial architecture, developing countries can limit external vulnerabilities by maintaining a competitive exchange rate. This would reduce vulnerabilities through at least three channels: (i) when a real currency appreciation is prevented, a speculative attack that would cause currency crisis is less likely; (ii) a competitive currency tends to lead to current-account balance and reduces the vulnerability to a sudden stop of capital inflows; and (iii) avoiding real currency appreciation goes hand in hand with the accumulation of international reserves which can provide a first line of defence if a currency attack or sudden stop were to happen.

Developing countries should also try to avoid (or limit) currency and maturity mismatches in both private and public balance sheets. Debt management policies aimed at substituting foreign-currency-denominated public debt with domestic-currency-denominated public debt can help. Also useful is regulation limiting the ability of households and corporations that have domestic currency income to incur debt denominated in foreign currency.

Finally, says the report, developing countries should have contingency plans to be implemented if all else fails. Moderately intrusive capital controls can help during crisis periods, and market-friendly capital controls can limit risk accumulation in good times.

In the context of the present crisis, several authors have again suggested reconsidering the use of restrictions on international capital mobility, such as international taxes or national capital controls, as a means of reducing the risk of recurrent international financial crises. This option may be all the more relevant as efforts to strengthen international prudential regulation may not keep up with financial innovation.

Noting that the introduction of a tax on international financial transactions has recently received renewed attention, the report says that such a tax would not prevent imbalances in the external accounts; but by reducing the possible gains that can be had from interest arbitrage and exchange-rate movements, it would help to reduce the amount of potentially destabilising speculative capital flows among countries that apply the tax (and in the system as a whole if a sufficiently large number of countries applied it).

Another approach to crisis prevention is to put in place measures that hinder the free inflow and outflow of private capital in individual countries. For a long time, the idea of capital controls was taboo in mainstream discussions of appropriate financial policies, as market forces were considered the only reliable guide for the allocation of capital. Experience with the current financial crisis also challenges the conventional wisdom that dismantling all obstacles to cross-border private capital flows is the best recipe for countries to advance their economic development.

A regulatory regime of comprehensive capital-account management can target both the level and the composition of capital flows. A rich menu of both price-based and quantity-based types of instruments can be combined and flexibly handled to match specific local requirements, the report stresses.

Another issue that has received renewed attention in the discussion about necessary reforms of the international monetary and financial system is the role of the United States dollar as the main international reserve currency. The current international monetary system, with flexible exchange rates between the major currencies, the dollar as the main international reserve currency, and free international capital flows, has failed to achieve the smooth adjustment of payments imbalances.

An international reserve system in which a national currency is used as a reserve asset and as an international means of payment has the disadvantage that monetary policy in other countries cannot be designed independently from the monetary policy decisions of the issuing central bank. These decisions are not taken in consideration of the needs of the international payments system and the world economy, but in response to domestic policy needs and preferences in the country of the reserve currency.

Another disadvantage of the current international reserve system is that it imposes the burden of adjustment exclusively on deficit countries (except if it is the country issuing the reserve currency). Yet, to the extent that one or several countries run surpluses, one or several others must run deficits.

The asymmetry in the adjustment burden introduces a deflationary bias into the system, because deficit countries are compelled to reduce imports when their ability to obtain external financing reaches its limits, whereas surplus countries are under no systemic obligation to raise their imports in order to balance their payments.

According to the report, IMF policies support this bias by imposing conditions of restrictive policies on deficit countries in connection with its lending activities, rather than pressing surplus countries for more expansionary policies in connection with its surveillance activities.

The most important lesson of the recent global crisis is that financial markets do not 'get the prices right'; they systematically overshoot or undershoot due to centralised information handling, which is quite different from the information collection of normal goods markets. In financial markets, nearly all participants react in a more or less uniform manner to the same set of 'information' or 'news', so that they wind or unwind their exposure to risk almost in unison.

The 'constant RER' approach

The report recommends that a viable solution to the exchange-rate problem, preferable to any 'corner solution', would be a system of managed flexible exchange rates which aims for a rate that is consistent with a sustainable current-account position. Once a set of sustainable exchange rates is found and accepted by the countries, inflation differentials may be the main guide for managing nominal exchange rates in order to maintain the real exchange rates (RERs) at sustainable levels.

Management of the nominal exchange rate is therefore required to maintain stability in the RER, but the scope for an individual monetary authority to do so is limited. The situation would be quite different if exchange-rate management became a multilateral task in which countries whose currencies were under pressure to devalue were joined in their fight against speculation by the monetary authorities of those countries whose currencies were under pressure to appreciate.

An internationally agreed exchange-rate system based on the principle of constant and sustainable RERs of all countries would go a long way towards reducing the scope for speculative capital flows, which generate volatility in the international financial system and distort the pattern of exchange rates.

According to the report, a constant RER at a competitive level would achieve the following:

  • Curb speculation, because the main trigger for currency speculation is the inflation and interest rate differential. Higher inflation and higher interest rates would be compensated by the devaluation of nominal exchange rates, thereby reducing the scope for gains from carry trade.
  • Prevent currency crises, because the main incentive for speculating in currencies of high-inflation countries would disappear, and overvaluation, one of the main destabilising factors for developing countries in the past 20 years, would not occur.
  • Prevent fundamental and long-lasting global imbalances, because all countries with relatively diversified production structures would maintain their level of competitiveness in global trade relations.
  • Avoid debt traps for developing countries, because unsustainable current-account deficits triggered by a loss in international competitiveness would not build up.
  • Avoid pro-cyclical conditionality in case of crisis, because, if the system were to have symmetric intervention obligations, the assistance needed for countries under pressure to depreciate their currencies would come automatically from the partners in the system whose currencies would appreciate correspondingly.
  • Reduce the need to hold international reserves, because with symmetric intervention obligations under the 'constant RER' rule, reserves would only be needed to compensate for volatility of export earnings but no longer to defend the exchange rate.

Such a multilateral system based on the 'constant RER' rule would tackle the problem of destabilising capital flows at its source. It would remove the major incentive for currency speculation and ensure that monetary factors do not stand in the way of achieving a level playing field for international trade, the report concludes.

Kanaga Raja is Editor of the South-North Development Monitor (SUNS). This article is reproduced from SUNS (No. 6771, 14 September 2009), which is published by the Third World Network.

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