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Market crises through producing laws and regulations

Market crises through producing laws and regulations

States can protect against market crises through producing laws and regulations that move situations of economic uncertainty towards situations of risk. Critically discuss this claim with reference to ONE case study of your own choosing.

The financial crisis, born during the summer time of 2007 but still arguably alive in 2010, has revealed the malfunction of most banking and monetary regulatory components. Prudential regulation failed to prevent the meltdown. Market discipline neglected to send any warning signals – low risk premiums, high ratings. Internal control was seriously undermined in France by doubtful dealings such as the Société Générale, Caisse d’épargne and Madoff affairs on a larger scale. The big three are nevertheless the basis for today’s financial regulation and this situation is the result of a slow process of evolution.

2The reforms that provided climb to “financial protection nets” inside the 1930s in america – e.g. the 1933 Business banking Take action – then in submit-warfare Europe and also in Japan had been all initially motivated from the need to swap dysfunctional industry control. The resurgence of economic imbalances in the 1970s did, however, give financial operations a massive shot in the arm. Three factors brought about new financial needs and prompted the creation of new financial products and new markets: first, the petrodollars from the oil-price shocks, recycling surpluses from oil-producing countries; second, the unstable interest rates subsequent to post oil-price shock inflation and the monetary change in course in the United States in 1979 with Paul Volker’s arrival as head of the Fed; and third, the fluctuating exchange rates related to the collapse of the Bretton Woods system in 1973. The boom in the capital market then automatically caused banking activity to evolve and the regulatory framework of the banking sector necessarily had to adapt accordingly. The new regulation, termed “prudential” (minimum capital requirement), set up from the end of the 1980s, no longer attempted to substitute for the market mechanisms, but rather to limit risk taking by banks. Market logic gradually found its place again in the banking sector, with the suppression of credit constraints, the liberalization of rates and the privatization of financial institutions among others, and held financial institutions to the relevant potential sanctions, such as investors’ demand for profitability, threats of buyouts, and the variability of resource costs. Rising risks also made banks more sensitive to the need to manage risks and prompted bankers to adopt suitable evaluation and risk management tools. Along the way, internal control was developed to the extent that major international banks endeavoured to get international authorities to recognize the use of these tools. From the mid-1990s, the Basel Committee on Banking Supervision recommended authorizing banks to use their internal “value at risk” models to calculate their capital needs. As a result, the relationship between regulation, internal control and market discipline gradually grew stronger.

3Does the problems phone the important three into issue? Will it entail massive backtracking in regulation? In order to answer these questions, let us begin with a simple principle put forward by the 2009 Nobel economics Prize Oliver Williamson in analyzing governance modes. No regulation mechanism is omniscient, whether it be state, market or self-regulation. As such, none of three can operate without the other two, with the corollary that they can only function together. Splitting up the big three can therefore not be the answer to the crisis. By contrast, since each one of them has shown its weaknesses, the only solution is to work on reinforcing each one. In that view, the paper proceeds as follows. Section 2 deals with the weak points of prudential regulation and discusses the progress that we can expect from the future Basel 3 agreements. In Section 3, we underline the weak points of internal control and we try to show that the fault line does not reside in the linkage between internal control and supervision as such, but rather in the evolution of internal control during recent years. Section 4 focuses on the weak points of market discipline, stressing problems and the way forward. Section 5 is the conclusion.

Through the 1980s on, regulators’ consideration focused on the solvency of financial institutions, which searched for instruments that could enable them to minimize the regulatory price of capital, as a way to “manage” regulatory constraint and also possible. This is the context where securitization and credit derivatives developed, allowing banks to reduce the denominator of the Cooke ratio to a minimum. With the help of this circumvention, bank balance sheet solvency – as evidenced by regulatory ratios – improved from 1990 to 2000. By contrast, during this same period, balance sheet liquidity as measured by the share of liquid assets steadily broke down. Charles Goodhart (2008) cites an article by Tim Congdon where he mentions the fact that British banks in the 1950s held a large percentage of liquid assets, around 30 percent of their balance sheet, in the form of treasury bonds or short-term public securities. Fifty years after, they hold no more than 1 percent. The deterioration in liquidity did not raise any concern, since asset liquidity has habitually become associated more with the dynamism of a given market than with the short maturity per se of the assets. Yet it is the incapacity of certain financial institutions to be able to mobilize liquid assets that caused the difficulties. Certain assets supposedly “easy” to sell owing to the dynamism of their secondary market before the crisis simply saw their market literally devastated by the crisis.

7Since then, liquidity continues to be a vital “work site” for regulators, yet it is nevertheless a challenging one particular. International negotiations on the subject failed in the 1980s. The crisis has unquestionably underscored the importance and urgency of regulation, but what still remains to accomplish is to reconcile widely varying national practices and impose a measure which will, however, be simple. Several routes can be envisaged. The transformation of maturity can be limited by forcing banks to match a percentage of the resources they collect with assets of the same maturity or impose a minimum ratio of liquid assets/total assets in the balance sheet. There is a trade off between these two possible approaches, since limiting transformation reduces the requirement for liquid assets and, on the contrary, having more liquid assets allows less constraint on transformation. What remains to be found is the optimum relationship between these two types of requirement. It will also be necessary to achieve a harmonized definition of liquid assets. To this end, will it be necessary to consider the maturity, the degree of standardization, the secondary market’s volume of activity for the relevant assets, or some other criterion? Liquidity remains a complex concept and this will inevitably pose a problem in agreeing on a harmonized definition internationally.

8In the Consultative File (2009) planning the approaching Basel contracts (Basel 3), the Basel Committee offered two proportions: a Liquidity Insurance Rate (LCR) and a Net Steady Financing Rate (NSFR). In both cases, the idea is to reinforce the capacity of banks to withstand shocks. The first ratio would make banks hold a stock of high-quality liquid assets enabling them to “survive” their commitments for 30 days, while the second is a structural liquidity ratio valid over a longer timeframe that would force banks to hold more stable resources (one year):

11The liquidity “work site” does not only increase difficulties of parameterizing equipment and harmonizing definitions, furthermore, it entails banks’ very raison d’être much more fundamentally. Economic literature grants banks two main reasons for existing. The first is related to the problems of informational asymmetry between lenders and borrowers which may make a direct transaction, like issuing securities, impossible on the market. The second concerns the liquidity service that banks are capable of providing to depositors, while also allowing borrowers long-term financing. This liquidity service provided by banks inevitably exposes them to the risk of illiquidity. As shown by the reference model established by Douglas Diamond and Philip Dybvig (1983), banks would not provide depositors with this assurance of liquidity if they were seeking perfect congruence for their liabilities and assets. In this case in fact, there would be no risk-sharing between depositors who have made short-term investments and those who have invested their money for the long haul. In addition, banks’ contribution to long-term financing would be restricted to resources collected in the long term. This means that the illiquidity risk is a component of banking activity. It is banks’ weakness as well as their justification for existing. Consequently, if banks’ exposure to the risk of illiquidity is reduced, their capacity for transforming short-term resources collected from depositors into long-term financing for the economy is also reduced. This is what makes the “work site” such a difficult one: the illiquidity risk needs to be reduced without totally undermining banks’ reason for being. By undermining banks’ raison d’être, it is their contribution to long-term financing that is jeopardized.