The Global Financial Crisis: Regulatory Implications

13/11/2008

In the perpetuation and fostering of a research framework between FEPS and the “Initiative for Policy Dialogue” (IPD, Columbia University) launched in August 2008, E. Stetter (FEPS, Secretary General) and the economic consultants for FEPS (M.J. Rodrigues & M. Méaulle) were invited to attend “The Global Financial Crisis” conference organised jointly by the IPD and the Friedrich Ebert Stiftung. This conference was divided in three parts.

The first one was intended to assess the sources of the present financial crisis. In the second one, the participants were asked to present the different regulatory measures which should prevent the repetition of such dramatic phenomena. Finally, the third part was devoted to a reflection on the international organization of a regulatory framework for a sound international balance of power.

The conference was aimed at answering a set of questions on the possible regulation packages to reduce risks of future crises while encouraging a financial sector that serves the real economy. Indeed, it has been pointed out that the ideology making deregulation a prerequisite for capital accumulation and growth had to be amended. Good regulation packages, by reducing the risk of systemic crises, can be effective and powerful tools to attract capital: “In particular, how can incentives be modified to reduce excessive risk-taking, how can excessive leverage best be controlled in boom times, how to avoid overvalued assets during booms for feeding into leverage, and how comprehensive should the new regulation be?” These packages must limit both negative impacts of the financial crisis on the real economy and an excessive burden on tax payers while creating incentives to re-direct investments towards people needs.

The assessment of the present financial crisis presented the roots in both the deregulation and free-market ideology and in the concentration of the banking and financial activities during the 1990’s. This created a confusion between banking and financial activities and the ground for an extraordinary growth of the finance sector. It induced financial actors, namely mortgage financial institutions, to externalise credit default risks through investment bank activities that were able to sell these risky derivatives to various financial entities that were also able to secure their risk against swaps. This development of finance as a sector of production when it should be a tool in order to make capital liquid shaped an architecture of the financial system characterised by a lack of simplicity, of prudence and of transparency: “Instead of managing risk, the financial sector often created risk”. Indeed, as was revealed by one of the participants, it created the incentives to make the contracts the most difficult to understand both for the competitors in the finance industry and for the lenders.

Basel II agreements also created the incentives to weaken the link between the real economy and the finance sector. All Participants, from this point of view, called for a Basel 0, a new Basel not exclusively based on self-regulation.

However, even if all the participants called for new regulation tools, it has been argued that a new architecture of the financial system, given the different economic states of each region, would surely call for, notably in the United Sates of America, strong and large fundamental global and structural reforms. The United States of America sustained a world finance-led growth through indebtedness. A rise of the global aggregate demand cannot be financed by America alone anymore and this calls for a re-organization and major adjustments in the global economy’s production patterns.

Nevertheless, it seemed that all the participants agreed on two pillars in order to prevent a repetition of the financial crises and their damages on the real economy. Each of them is complementary to the other. Banks, first, should be inclined to let inspectors evaluate the risks of default of their lending activities, especially during boom periods. However, as rightly pointed out, these measures, on their own, in countries inclined to act in such a way, did not prevent some economies to enter recession. In addition, therefore, one should also be inclined to assess the tools used for such evaluations. It was argued that these models are either short-termist or fail to integrate longer term prospects in order to include the possibility of systemic crises. During periods of recession, however, it has been argued that mathematical models used to evaluate assets (mark-to-market) should be revised, given their function as catalyst to the recession. In other terms, all participants called for the implementation counter-cyclical measures to prevent the diffusion of crises in the economy.

Participants also called for a recasting of the monetary policy regime. If liquidity, financial stability and growth require diversity, “how speculative behaviors can be curbed?”1. All participants called for a low interest rate regime to support aggregate demand and recover a stable growth path, or at least to recover the confidence in the possibility of reaching such a state. However, should this stimulus be directed towards finance or towards the real economy? Both, answered one of the participants: an investment is a risk both with regard to the product bought or the investment done as well as with the means used to finance it. The evaluations of risk should therefore be run in these two respects, by independent and perhaps publicly funded institutions: “It is therefore essential to design good regulation that will lead to innovations that serve, and do not harm, the real economy. This would for example imply creating mortgages that help people stay in their homes, as well as instruments to finance future-oriented investment which would support the necessary structural changes in the economy” In this respect, one of the participants warned against the idea that the only problem in the apparition of the present financial and economic crisis was due to a lack of information and that consequently a good and fair measure of regulation could be limited to a call for transparency. The solution cannot only be a pricing of such asymmetries, market imperfections and externalities. There is a strong need for a regulation of leverage activities. It is not saying that leverage is a bad tool for allocating capital in the economy per se but that its use as a means to acquire profits in the very short term without any economic or political vision other than the expected profitability should be amended.

Nonetheless, as stated by one of the participants, the present economic and financial crisis could have been forecasted either from an analytical point of view or just through the news. Derivatives were labelled “financial mass destruction weapons” and the crisis in the real economy was already appearing last year when consumption goods prices, in response of the speculative activities in these markets, were increasing drastically. This let the participants believe that the right regulation packages could be implemented and could be a useful tool to prevent the repetition of such damaging phenomena. From a global point of view, all participants agreed on the difficulty to implement a democratic world finance authority. The last could spring from the rapprochement of the FSF (“Ideas with no power”) and the IMF (“Power with no idea”) coupled with a systemic regulation management. One could also implement colleges of supervisions for firms in charge to examine what each of them is doing and the expected projections of their investments.

In all cases, the most difficult task but also the one which will be the most fructuous is to find a way to change the behaviours of the CEO and corporate governance schemes of the finance sector: finance should be “a good servant of the real economy”. Their power over the economy as a whole has to be managed or regulated, as was revealed by the necessity to re-organise the financial architecture towards smaller banking and financial entities. The last being the only ones to be able to evaluate accurately both people needs and the relative risk associated to them.

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