A number of international summits have endorsed proposals for the introduc- tion of countercyclical capital adequacy standards and international supervision of systemically important institutions, including the upgrading of the functions of the Financial Stability Forum. Both of these measures, if implemented, could be a significant improvement in the international supervision of global financial institutions. However, such improvement will prove insufficient to prevent those institutions from building very risky positions that may lead to a systemic crisis, unless the current model of banking regulation is subjected to radical rethinking and an international regime is established that is designed to deal with the systemic risks posed by the market activities of IIFs.
A Proposal for Reform of Banking Business
The regulatory reforms endorsed in the London and Washington summits, while constituting substantial improvement, do not address the impact of the discussed above sociopsychological aspects of market behavior. Therefore, more radical pro- posals must be considered, which should also take into account the cognitive limitations of market actors. In the paragraphs that follow, I provide a model for the radical reform of banking regulation and the establishment of a global regime for the prudential regulation of IIFs.
Under Exhibit 49.1, current account deposits that are more susceptible to bank runs are received only by Tier I banks and savings institutions that operate under the strictest regulatory framework. Also, the securitization of bank loans (assets) that may weaken a bank’s balance sheet and make creditors unwilling to lend to it is substantially restricted. Finally, cross-shareholdings between the institutions of each Tier should not exceed 20 percent. These restrictions ensure that systemic risk does not return to the savings and loans industry by virtue of substantial cross-shareholdings (ownership participations).
A Global Licensing Regime for Systemically Important Investment Funds
The systemic importance of big hedge funds and their widespread involvement in credit markets, as well as their role in exacerbating the present crisis, has high- lighted the need to design a suitable regulatory regime dealing with these highly leveraged investors. A regulatory regime extending to hedge funds may only
Exhibit 49.1 A New Model for Bank Authorization and Supervision
Permitted Activities
Type of License
Deposit Insurance
Capital Adequacy
Liquidity Insurance
Prohibited Activities
r Deposit taking
r Consumer lending
r Mortgage Lending
r Corporate Lending
r Leasing r Treasury & FX
Operations
r Lending to Inter-bank markets up toe.g., 30% of total deposits
Tier I Savings and Loans Institution
90%+up to a limit that covers all small and medium size deposits Prefunded but coinsurance scheme
Basel II (as revised)
Lender of Last Resort (inevitably at subsidized rates) but prefunded scheme
Balance sheet securitization up to 30–40%
of total assets Treasury and FX operations only in connection with balance sheet management
Permitted Activities
Type of License
Deposit Insurance
Capital Adequacy
Liquidity Insurance
Prohibited Activities
r Issuing of short-term certificates of deposit and bills, and long-term bonds to the public
r Mortgages r Corporate Lending,
Leasing
r Treasury & FX Operations
r Asset Management
r Client Broking
r Limited ability to underwrite securities issues/take
proprietary positions
Tier II Bank 50% of total short-term debt issued to savers Prefunded Scheme
Basel II (as revised)
Lender of Last Resort (inevitably at subsidized rates) but prefunded scheme
No
under writing of securities or proprietary trading exceeding a ratio over (e.g., 300%) shareholders’
equity No current account deposits
Permitted Activities
Type of License
Deposit Insurance
Capital Adequacy
Liquidity Insurance
Prohibited Activities
r Full range of capital market activities
r Trading (proprietary) in derivatives
r Trading (proprietary) in securities
r Underwriting
r Broking
Tier III Firm Investment Bank, or Investment (Securities) Firm
None Basel II (as revised)
Liquidity insurance from Central Bank or private provider at market rates
No deposit taking No short-term debt issued to the public
396 The Problem of Regulation
prove successful, however, if it has a global reach. It is therefore suggested that a World Investment Funds Authority (WIFA) be established that would deal with the licensing and supervision of certain aspects of the operation of systemically important international investment funds.
The criteria for bringing within the WIFA scheme funds engaging in investment and trading activities with an international focus should relate to the size of funds’
balance sheet and gearing ratios. Admittedly, such a scheme would prove totally ineffective if sovereign wealth funds, some operating with substantial borrowings (leverage), were not also brought within the regulatory reach of the WIFA, in spite of such a suggestion creating serious political opposition and controversy.
The scheme would work on the basis of a global common operating license (passport), and the funds that have opted to stay outside the scheme could be legally disbarred from undertaking significant (above a specified threshold) trading or investment activities in the markets of participating states.
IIFs should be allowed to register with the scheme under two conditions: (a) provide the WIFA with full access to information regarding the composition and structure of their balance sheets (but not to the composition of their membership, which is a sensitive issue, especially for SWFs) and (b) prove that they have (i) subscribed with a new (pre-funded) global liquidity or systemic risk insurance scheme for IIFs, administered by the IMF, or (ii) entered into pre-funded liquidity support or systemic risk insurance arrangements provided by central banks from a G-20 country or by a credible private organization. The more leveraged the positions that the funds wished to take, the higher the systemic risk premium that the suggested liquidity insurance scheme would charge.
A New Approach to Financial Regulation
Systemic instability can cripple a country’s economic life and threaten the health of the global financial system, including a cessation of payments and other transna- tional flows of funds, if it has international dimensions. It may also adversely affect global growth. The model of national and international financial regulation presented here successfully addresses several of these concerns. The proposed scheme’s advantages may be summarized as follows:
r It battles homogenisation:13 Segregation seems to be the only effective pol- icy tool that can lead the global financial services firms to diversify their activities, lowering the destructive potency of endogenous risk.14
r Better management of risk: It sends credit risk to savings and lending insti- tutions, where it can be best measured and managed, preventing AIG-type collapses.
r Improved consumer service:Creating banks that specialize in certain areas of consumer and business lending might mean better services for bank cus- tomers.
r Protection of public funds: The suggested model of segregation drastically limits the ability of banking institutions to free ride on the public guarantee.
Implementation of the Exhibit 49.1 model would lead to the ring-fencing of the loans and savings sector from excessive speculation.
r Complexity reduction and effective supervision:The limits placed by the present proposal on the ability of savings and lending institutions to securitize their assets and engage in derivatives trading would drastically reduce the com- plexity of their operations. As a result, the effectiveness of regulatory super- vision would improve dramatically.
r A transparent and workable global regime for IIF supervision:The objective of the suggested regime for IIFs targets the social costs of IIF activities. An obligation to buy liquidity insurance, for instance, would curb their ability to free ride on the implicit public guarantee enjoyed by their lender banks.
r Restraining the “animal spirits” of the market:Segregation, position limits, and liquidity insurance would drastically restrain the otherwise uncontrollable behavioral tendency of bankers and fund managers to focus on short-term profit.
CONCLUSION
The global financial crisis has shown that the systemic threats posed by irrespon- sible practices within the financial services industry can cause the collapse of the international financial system. Because of the behavioral factors discussed earlier, many of the current reforms will prove insufficient to prevent excessive risk taking.
This will especially be the case during the next period of market euphoria.
This paper has argued for a new global regulatory consensus with respect to the radical redrawing of the current model of national and international financial regulation. It has proposed mandatory institutional segregation for the banking industry along business lines. The paper has also suggested the establishment of a global licensing and supervisory scheme for international investment funds. The reforms suggested here are expensive, but, if adopted, they would also prove to be effective at averting another crisis of this magnitude.
NOTES
1. Core Principles for Effective Banking Supervision(Basel Committee on Banking Super- vision, September 1997, revised in October 2006).International Convergence of Capital Measurement and Capital Standards, A Revised Framework(Basel Committee on Banking Supervision, updated November 2005).
2. Gramm-Leach-Bliley Financial Services Modernization Act, Pub. L. No. 106–102, 113 Stat. 1338 (1999).
3. Directive 89/646/EEC [1989] OJ L 386/1, replaced by Directive 2006/48/EC [2006] OJ L 177. The Second Banking Directive allowed deposit-taking European banks to also engage in the kind of investment market activities that were usually reserved, at least outside of Germany, for securities firms and non-deposit-taking investment banks.
4. Normally, the original lender (theoriginator) is also responsible for carrying out due diligence regarding borrowers’ creditworthiness and ensuring that the terms of the mortgage appropriately reflect the risks of the transaction. However, at the point of origination, credit controls gradually became increasingly compromised.Originators were paid by reference to the amount of loans generated, regardless of the repayment rate of those loans. As a result, they had every incentive to maximize the volume of loans granted independently of controls on borrower creditworthiness.
398 The Problem of Regulation
5. The fundamental assumption of rational choice theory about financial markets is that markets move only on the basis of rational expectations, namely, asset prices are set by rational investors. Based on rational choice theory, the efficient market hypothesis (EMH) assumes that market prices reflect equal fundamental value and change because of new information. Thus, in an efficient market, no investment strategy can yield av- erage returns higher than the risk assumed (“there is no free lunch”) and no trader can consistently outperform the market or accurately predict future price levels, because new information is instantly absorbed by market prices. Another EMH assumption is that markets give professional traders the opportunity to quickly observe and exploit through arbitrage trading any price deviations from fundamental value. Behavioral fi- nance challenges most of the assumptions of EMH. The main tenets of behavioral finance are that: certain market phenomena calledanomaliesorpuzzlesmay not be explained by the EMH, whereas the use of psychology can provide convincing explanations and the corrective influence of arbitrage trading is limited because of a number of restrictions.
6. President’s Working Group Report, 16, 8.
7. This concept describes individuals’ limited ability to process information because they possess “limited computational skills and seriously flawed memories.”Bounded rational- itywas first discussed as a potential determining factor in decision making by Herbert Simon.
8. IMF, 55.
9. Ibid.
10. Carney, 3–4.
11. Therepresentativeness heuristicis used by individuals to evaluate probability. Much of the time,representativenessis a helpfulheuristic, but it can generate some severe biases. The availability heuristiccontrols estimates of the frequency or probability of events, which are judged by the ease with which instances of such events come to mind.Anchoring refers to the process by which an individual decision maker gravitates to a reference point that she subsequently uses as an initial condition for arriving at a final decision.
12. IMF, 56.
13. This is the term used for the widespread tendency of market players to all move in the same direction at once. This tendency was significantly exacerbated by financial conglomeration, which resulted in the formation of megabanks.
14. ‘[E]ndogenous risk means that any financial assets fluctuations are. . .explained only by the very behavior of the participant or the participants that prize that financial asset, and not by exogenous factors. . .’ Fischer, 124–125.
REFERENCES
Avgouleas, E. 2009. The global financial crisis, behavioural finance and financial regulation:
In search of a new orthodoxy.Journal of Corporate Law Studies9:121.
Barberis, N., and R. Thaler. 2002.A survey of behavioral finance. National Bureau of Economic Research, working paper 9222.
Basel Committee on Banking Supervision. 1997, 2006.Core principles for effective banking supervision.
———. 2005.International convergence of capital measurement and capital standards: A revised framework.
Brunnermeier, M., A. Crockett, C. Goodhart, A. D. Persaud, and H. Shin. 2009.The funda- mental principles of financial regulation. Geneva Reports on the World Economy.
Carney, M.Addressing financial market turbulence. Remarks of the Governor of the Bank of Canada to the Toronto Board of Trade, March 13, 2008.
Chevalier, J., and G. Ellison. 1999. Career concerns of mutual fund managers.Quarterly Journal of Economics114 (2): 389–432.
Fischer, L. 2007. Major risks of international banking. InLaw and economics of risk in finance, P. Nobel and M. Gets (eds.). Z ¨urich: Schulthess.
Financial Services Authority. 2009.The Turner review: A regulatory response to the global banking crisis. London: FSA.
G-20 Washington Summit. 2008.Declaration of the Summit on Financial Markets and the World Economy.
G-20 London Summit. 2009.Joint Communique.
Gompers, P., and A. Metrick. 2001. Institutional investors and equity prices.Quarterly Journal of Economics116: 229–259.
International Monetary Fund. 2008.Global financial stability report: Containing systemic risks and restoring financial soundness. Washington, DC: IMF.
———. 2008.Financial stress and deleveraging: Macrofinancial implications and policy. Washing- ton, DC: IMF, Global Financial Stability Report, (IMF2).
The President’s Working Group on Financial Markets (PWGFM). 2008.Policy Statement on Financial Market Developments.
Schwarcz, S. 2008. Disclosure’s failure in the subprime mortgage crisis. Utah L. Rev.
1109–1122.
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Simon, H. A. 1955. A behavioral model of rational choice.Quarterly Journal of Economics69 (1): 99–118.
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ABOUT THE AUTHOR
Emilios Avgouleasis a reader (senior associate professor) in international finan- cial law at the School of Law, University of Manchester. Emilios holds an L.L.M. in banking and finance law (1995) and a Ph.D. in law and economics (1999) from the London School of Economics. He has very extensive academic and legal practice experience in the field of financial markets. He is the rapporteur of the Interna- tional Securities Regulation Committee of the International Law Association. In the spring term of 2009 he was the global capital markets center fellow at Duke University Law School. His publications include:The Mechanics and Regulation of Market Abuse: A Legal and Economic Analysis(Oxford University Press, 2005);The Governance of Global Financial Markets and International Financial Regulation(Cam- bridge University Press, 2010); “The Global Financial Crisis, Behavioural Finance and Financial Regulation: In Search of a New Orthodoxy,”Journal of Corporate Law Studies9 (2009): 121–157; “A New Framework for the Global Regulation of Short Sales: Why Prohibition is Inefficient and Disclosure Insufficient,”Stanford Journal of Law Business and Finance15 (1) (2010).
PART VII
Institutional Failures
Lessons from the Financial Crisis: Causes, Consequences, and Our Economic Future by Robert W. Kolb Copyright © 2010 John Wiley & Sons, Inc.
CHAPTER 50
Why Financial Conglomerates Are at the Center of the
Financial Crisis
ARTHUR E. WILMARTH JR.
Professor of Law, George Washington University Law School∗
The global economy is currently experiencing the “most severe financial crisis since the Great Depression.”1The ongoing crisis has battered global finan- cial markets and has triggered a worldwide recession. Global stock market values declined by $35 trillion during 2008 and early 2009, and global economic output was expected to fall in 2009 for the first time since World War II.2
In the United States, where the crisis began, markets for stocks and homes suffered their steepest downturns since the 1930s and drove the domestic economy into a steep and prolonged recession. The total market value of publicly traded U.S. stocks slumped by more than $10 trillion between October 2007 and February 2009. In addition, the value of U.S. homes fell by an estimated $6 trillion between July 2006 and the end of 2008. U.S. gross domestic product declined sharply during 2008 and the first quarter of 2009, and five million jobs were lost during the same period. Many sectors of the credit markets essentially ceased to function.3
The turmoil in global and domestic financial markets reflected deep concerns among investors about the viability of major financial institutions. Commercial and investment banks and insurance companies around the world reported more than
$1.1 trillion of losses between August 2007 and March 2009. To prevent the collapse of the global financial system, central banks and governments in the United States (U.S.), United Kingdom (U.K.) and Europe provided almost $9 trillion of financial support in the form of emergency liquidity assistance, capital infusions, asset purchase programs, and guarantees. U.S. federal agencies extended about half of that support. Nevertheless, the ability of global financial markets to recover from the crisis remained in serious doubt in May 2009.4
This chapter documents that 17 major financial conglomerates accounted for a majority of the losses reported by global banks and insurers from the beginning
∗This essay is adapted from portions of the following article: Arthur E. Wilmarth Jr., “The Dark Side of Universal Banking: Financial Conglomerates and the Origins of the Sub- prime Financial Crisis,”Conn. L. Rev.41 (2009): 963, available at http://ssrn.com/abstract=
1403973.
403 Copyright © 2010 John Wiley & Sons, Inc.
404 Institutional Failures
of the crisis through April 2009. In view of the huge losses suffered by these giant institutions, and the extraordinary governmental assistance they received, they clearly were the epicenter of the crisis. They were also the primary private-sector catalysts for the credit boom that led to the crisis.
During the past two decades, governmental policies in the United States, the United Kingdom, and Europe encouraged massive consolidation and conglomer- ation within the financial services industry. The Gramm-Leach-Bliley Act of 1999 (GLBA), which authorized U.S. banks to affiliate with securities firms and in- surance companies, was part of a strong international regulatory trend in favor of universal banks.5 Domestic and international mergers among commercial and investment banks and insurers produced a dominant group of large complex fi- nancial institutions (LCFIs). By 2007, 17 LCFIs effectively controlled domestic and global markets for debt and equity underwriting, syndicated lending, asset-backed securities (ABS), over-the-counter (OTC) derivatives, and collateralized debt obli- gations (CDOs).6
Universal banks exploited their dominance of global financial markets by pur- suing an originate-to-distribute (OTD) strategy. The OTD strategy included:
r Originating and servicing consumer and corporate loans r Packaging those loans into ABS and CDOs
r Creating additional financial instruments, including credit default swaps (CDS) and synthetic CDOs, whose values were derived in complex ways from the underlying loans
r Distributing the resulting securities and financial instruments to investors LCFIs used the OTD strategy to maximize their fee income, reduce their capital charges, and transfer to investors (at least ostensibly) the risks associated with securitized loans and other structured-finance products. However, because many financial conglomerates followed similar OTD strategies, their common exposures to a variety of financial risks—including credit risk, market risk, and liquidity risk—produced a significant rise in systemic risk in global financial markets.7
Even before the subprime lending boom began in 2003, some observers raised questions about the risks and conflicts of interest created by the new universal banks. For example, LCFIs played key roles in promoting the dot-com-telecom boom in the U.S. stock market between 1994 and 2000, which was followed by a devastating bust from 2000 to 2002. Many leading universal banks were also involved in a series of scandals involving Enron, WorldCom, investment ana- lysts, initial public offerings, and mutual funds during the same period. However, Congress did not seriously consider whether financial conglomerates posed a se- rious threat to the stability of financial markets and the general economy. Instead, political leaders assumed that federal regulators and market participants would exercise sufficient control over universal banks.8
The United States experienced an enormous credit boom between 1991 and 2007. Household debt rose by $10 trillion (to $13.8 trillion), nonfinancial business debt grew by $6.4 trillion (to $10.1 trillion), and financial sector debt increased by
$13 trillion (to $15.8 trillion). As a result of this credit boom, the financial services industry captured an unprecedented share of corporate profits and gross domestic