Title: A Financial Pre-Cautionary Principle: New Rules for Financial Product Safety Gerald Epstein Department of Economics and Political Economy Research Institute (PERI) University of Massachusetts, Amherst USA
1A Financial Pre-Cautionary Principle New Rules
for Financial Product SafetyGerald
EpsteinDepartment of Economics and Political
Economy Research Institute (PERI)University of
Massachusetts, AmherstUSA
- IDEAS Conference
- Chennai, India
- January 24 27, 2010
2Joint Work with James Crotty
- Based on Epstein and Crotty, Avoiding Another
Meltdown Challenge Magazine, January-February,
2009 and A Financial Precautionary Principle
New Rules for Financial Product Safety - And James Crotty, Structural Causes of the
Global Financial Crisis, - found at www.peri.umass.edu
3"The world is on the edge of the abyss because of
an irresponsible system" French Prime Minister,
Francois Fillon, Financial Times, October 3, 2008
4Causes of Financial Crisis
- Neo-liberalism and inequality at core of crisis
- But here I want to focus on one aspect of this
- System of light-touch Financial Regulation and
its interaction with the New Financial
Architecture best illustrated by the Originate
and Distribute Model of Finance
5(No Transcript)
6Alan Greenspan Testimony, 23/10/08
- Those of us who have looked to the self-interest
of lending institutions to protect shareholders
equity, myself included, are in a stated of
shocked disbelief.
7Alan Greenspan, Congressional testimony,
23/10/08, on regulation
- I made a mistake in presuming that the
self-interests of organizations, specifically
banks and others, were such as that they were
best capable of protecting their own shareholders
and their equity in the firms
8In other words, you found that your view of the
world, your ideology, was not right, it was not
working, Mr. Waxman said.
- Absolutely, precisely, Mr. Greenspan replied.
thats precisely the reason I was shocked,
because I have been going for 40 years or more
with very considerable evidence that it was
working exceptionally well.
9Longer Term Perspective 1900 -2008
Current Crisis
Source Reinhart and Rogoff, 2008a
10In U.S. New Deal Regulation of Finance
- Separation of commercial and investment Banking
(Glass-Steagall)? - Segmented Asset Classes and Institutions
- Restrictions on Securitization and other NEW
Financial Products
11New Deal System of financial Regulation Eroded in
the U.S. in the 1970s, and 80s
- Largely due to pressure from large banks and
their allies in the Fed, Treasury, Congress and
the White House
12Essence of the New Financial Regulatory System
- Self-Regulation
- Outsourcing Regulation
- Ineffective public regulation of only some of the
financial sector
13Self-Regulation
- -Banks develop own risk management systems
- _As part of the Basel Capital Requirements, use
their own Value at Risk models (VaR models) to
estimate how risky their assets were in order to
determine for themselves how much capital they
should hold to back these assets up.
14Outsourcing Regulation to Gate-Keepers
- Bond ratings agencies (Moodys, Standard and
Poors, Fitch)? - Accounting firms
15Ratings agencies
- Key problem conflict of interests
- Yet played quasi-official role in the system
- -- rated asset backed securities so that
pension funds and others could buy them - --- their ratings fed into the Basel
risk-adjusted capital requirements
16Creation of Un-regulated Shadow Banking System
- Over the Counter (OTC) Derivatives Markets
- Hedge Funds
- Private Equity Funds
17De-Regulation led to
- New Financial Architecture Originate and
- Distribute Model
18Structural Flaws In The New Financial
Architecture (NFA)?
- STRUCTURAL FLAWS IN THE NFA POWERED THE BOOM,
CAUSED THE CRISIS AND MUST BE FIXED
19Five Fatal Flaws of the New Financial
Architecture (NFA)?
- NFA Flaw 1
- Asymmetric and perverse incentives that led
virtually all actors to take excessive risk. - For example
- -Bankers made money on way up but didnt lose on
the way down - Credit Rating agencies paid to give
over-optimistic ratings
20NFA Flaw 2
- A regulatory framework that was lax at best and
that ignored the shadow banking system of hedge
funds, private equity funds and the like.
21NFA Flaw 3
- Financial innovations that led to assets that
were murky and opaque (non-transparent and
complex)? - This is the focus of this paper.
22NFA Flaw 4
- A system that was at root pro-cyclical in its
dynamics and led to excessive leverage.
23NFA Flaw 5
- The Financial System was too big, too complex and
too inter-connected to understand and to fail.
24Led to banking systems that are impaired or
insolvent
25Focus now on one aspect
- The Regulation of New Financial Products
26The Dangers of High Risk Financial Products
- High risk Financial Products were at root of
crisis - Collateralized Debt Obligations (CDOs),
CDOs-squared - Credit Default Swaps (CDS) (AIG, etc.)?
- others
27According to the Financial Times almost half of
all these credit products have now
defaulted, "these defaults have affected more
than 300 billion worth of collateralized debt
obligations
28Complex and Opaque Products
- Spread throughout the system in US and abroad
- 2. Led to crisis of confidence
- 3. Led to liquidity crises
29Complex and Opaque Products
- 4. Made it difficult for the Lender of Last
Resort (Fed, and other central banks) to save the
system from collapsing - 5. Now making it very difficult to revive the
financial systems productive role in the
economy because it has rendered so many financial
institutions insolvent and holding financial
assets that no one knows the values of.
30Such risky and opaque products should have been
tested before they could be sold.
- With a financial pre-cautionary principle, it is
very unlikely they would have been allowed to
have been sold
31Definition of Precautionary Principle
- The precautionary principle is a moral and
political principle which states that if an
action or policy might cause severe or
irreversible harm to the public or to the
environment, in the absence of a scientific
consensus that harm would not occur, the burden
of proof falls on those who would advocate taking
the action.
32Several Analysts have proposed that new financial
products be approved
- Joseph Stiglitz
- George Soros
- Daniel McFadden
- Martin Hellwig
- Others.
33No one has detailed how this would work in the
U.S. in the current period
- That is what we try to do in our paper
- A Financial Pre-Cautionary Principle New Rules
for Financial Product Safety
34There are precedents
- Malaysia
- India
- Spain
- Earlier precedents in the U.S. and Europe
35Indian Example
- Reserve Bank of India (RBI)?
- Governor Y.V Reddy
- Was the Devil
- Now
- He is the Hero who Saved the Indian Financial
System
36RBI Precautionary Principle for New Financial
Products
- According to the Bank Reserve Act of 1949
- Banks can carry out only those activities that
are permitted. - Engagement in some financial products are clearly
prohibited. - Other are clearly allowed.
- Then, there are those in between.
37Products neither permitted or allowed?
- Banks have clear sense that they should get
permission from the RBI before proceeding because
the RBI might take action later on that is costly
to them.
38With respect to new financial markets
- They must always get permission.
39New Products
- RBI is reluctant to issue formal approval of
products that it is not sure are safe. - So RBI issues safeguards and guidelines
- RBI monitors performance of products and then
might choose to tighten guidelines.
40Examples
- Only certain, plain vanilla derivatives are
allowed - Forwards
- Interest rate swaps
- Interest rate futures
- Structured Products cannot contain derivatives
that are otherwise prohibited
41Structured Products
- Market Makers must be able to mark to market or
demonstate prices by market prices - Must be contracted at prevailing prices
- (This makes it difficult to design complex
bestoke products )?
42Unique, important provision
- Banks can only offer complex derivatives if it
has an underlying exposure on account of
commercial transactions. - So complex bets on bets, such as Credit Default
Swaps are not allowed.
43More Capital required for structured products
- More capital has to be held by the originator for
complex structured products.
44Liberalization
- Many of these provisions are now being liberalized
45Approaches to Financial Preacautionary Principle
- Build on the Analogy of the RBI.
- Requires that Fed has the orientation of the RBI,
and wants to implement such a policy. It involves
a lot of discretion.
46Create New Authority
- Use Indian lessons, but create new authority with
the objective and culture designed specifically
to tackle this problem.
47Build on the analogy of the Food and Drug
Administration in the United States
- Drugs cannot be marketed unless they first get
approved by the FDA - Evaluation is divided in to two main stages
- Pre-Marketing Evaluation
- Post-Marketing Enforcement, regulation and
re-evaluation
48Financial Stability and Product Safety
Administration (FSPSA)?
- Stresses that the main concern is the impact of
financial products on over-all financial
stability - as well as on the health of institutions that
sell and buy the products. - Use of the term Administration stresses the
analogy with the Food and Drug Administration.
49FSPSA
- Implement the key principle New Financial
Products must be approved before they are
marketed. - Some will not be approved if they cannot be shown
to be effective and if their risk characteristics
are not sufficiently transparent or are to
dangerous for overall financial stability. - Those that are problematic but can be marketed
way have significant restrictions placed on their
sale and use.
50FSPSA
- For example
- They might only be able to be sold on a limited
basis to certain kinds of institutions - Those buying them may have to keep higher capital
or liquidity levels to support them - They might have to be priced at a higher level to
reflect the overall societal risk. - They might have a short sunset period after which
they would have to be re-authorized in order to
be marketed.
51Post-Marketing Phase
- All financial products would have a sunset clause
so they would have to be re-authorized after a
certain period of time - For very safe products, this would be highly
simple and routine. For more complex and risky
products, a more serious re-evaluation. - For all risky products, a well structured
mechanism must be in place for gathering data on
their performance and this data will be fed into
post-marketing evaluations
52Possible Objections to the Financial Stability
and Product Safety Administration
- Too difficult to identify risky products before
the fact. - 2. Will not be able to define acceptable risk
level - 3. Do not have the analytical tools to test
product safety. - 4. Will cut down too much on financial
innovation. - 5. The FSPSA will be subject to regulatory
capture
53Most of these objections can be answered
- There has already been a great deal of work
dealing with analytical and testing issues and
with the question of identifying acceptable risk
levels. We will not have to re-invent the wheel.
Can build on existing work. - BUT, Key difference this will be mandatory and
not voluntary
54Financial Innovation reduced?
- 2. We will show that the value of financial
innovation is highly uncertain and probably way
over-estimated. Reducing the rate of actually
existing financial innovation may well be
beneficial.
55Regulatory Capture
- A serious potential problem. Only solution is
serious democratic transparency and
accountability. - This includes getting money OUT OF politics.
56Characteristics of High Risk Products are well
known to bankers themselves
- They embody high leverage (note these are
embodied in products and not just institutions)? - They are prone to periods of large and rapid
reductions in market liquidity - They lack price transparency
- Often subject to maturity mismatches in funding
57Pre-testing products
- BIS, Federal Reserve, Banker Groups (Institute of
International Finance), others have guideliness
for product and stability testing - 1.Value at Risk (VaR) models based on data
- 2. Stress Tests simulations
- 3. Reverse Stress Tests simulations
- 4. More general analytics modeling and basic
analysis
58Problems with VaR
- Problems with Value at Risk modeling
- data based on boom periods lead to
under-estimation of risks - Data from earlier risky periods are not
applicable because there has been too much
structural change in financial markets
59Stress tests, reverse stress tests, and marginal
impact stress test may be more relevant
- Simulation not data based
- Can simulate major shocks
- Look at impact on behavior of products
- Reverse stress tests assume a shock big enough
to cause insolvency what dynamics would it
engender in products
60Marginal Impact Stress Tests
- Look at impact of big shocks with and without the
new product. - The difference is an estimate of the riskiness of
the new product - Vary quantity and distribution of products among
counter-parties.
61Main Point
- There are tools to be used. But nothing can
substitute from informed, knowledgeable common
sense - IF YOU CANNOT FIGURE OUT HOW RISKY THE ASSET IS
WITHIN REASONABLE LIMITS, DO NOT APPROVE IT.
62Product Recalls (as in drugs)?
- More complex with financial products
- --can lead to more financial instibility if
assets widespread - --can swap out assets
- --safer not to get into that problem in the first
place Higher Bar
63Pro-Cyclical Enforcement of Regulations?
- Regulators are also over-optimistic in boom.
- May need automatic counter-cyclical tightening of
regulations. - ---raise minimum risk levels in booms
- --higher capital and liquidity requirements for
new products during booms
64Will the FSPSA have a bad impact on financial
innovation?
- Motives for Financial innovation (Finnerty,
Tobin, et. al) - (1) reallocating risk
- (2) increasing liquidity
- (3) reducing agency costs
- (4) reducing transactions costs
- (5) reducing taxes
- (6) circumventing regulatory constraints
- (7) gaining first mover-advantages
- (8) open new venue for speculation (casino
motive) - (9) redistribute income from other stakeholder or
customer
65Only some reflect increases in efficiency.
66Motivations for Financial Innovation Finnerty
Studies
67James Tobin, 1994
- "The new options and futures contracts do not
stretch very far into the future. They serve
mainly to allow greater leverage to short-term
speculators and arbitrageurs and to limit losses
in one direction of the other. Collectively they
contain considerable redundancy. Every financial
market absorbs private resources to operate and
government resources to police. The country
cannot afford all the markets that enthusiasts
dream up. It should consider whether they really
fill gaps in the menunot opportunities for
speculation and financial arbitrage."
68Empirical Estimates of impact of Financial
Innovation on Growth, Productivity
- White and Fame 2004 JEL survey article
- Very little empirical evidence on the impact of
financial innovation.
69Other issues
- Financial Patents
- recently became legal (State Street Case, in the
U.S.) - so far, not very important dont led to more
RD perhaps FSPSA will lead to greater
importance
70Regulatory Capture
- More Serious Problem
- Need Community Oversight Boards oversight of
FSPSA - Truly independent academic experts to serve on
testing and monitoring boards - 3.More objective academic research on financiai
product impacts and testing
71Academic Capture
- Big Problem in this area (as with scientists and
drug testing)? - Many finance academics work part-time for
financial firms, get grants from them and/or are
owners of such firms. - Makes it difficult to get truly independent
analysis about the effectiveness and riskiness of
financial products.
72Lawrence Summers
- A partner of D.E. Shaw a major hedge fund and
also an Economics Professor at Harvard. - (Now Obamas chief economic advisor)?
73Avoiding Academic Capture
- FSPSA well paid positions for financial
economists - Research Grants/Post Docs for young economists
- High Quality Refereed Journals for young
economists working in these areas - Presigious academic conferences to present work
- Help Re-enforce ethics rules at Universities on
conflicts of interest.
74What about reforming the financial sector more
generally?
75 Program For Re-Regulating the U.S. Financial
Markets
- These points are organized according to helping
to solve the four fatal flaws of the NFA. - --There is over-lap, redundancy and multiple
fire-walls. - It is important to have redundancy because if
financial markets find a way around one fire
wall, we want another one to be able to catch
them.
76I. Reduce Asymmetric Incentive Structures and
Moral Hazard
- 1. Transform financial firm incentive structures
that induce excessive risk-taking. - Examples
- -implement clawbacks through which excessive
salaries and bonuses paid during the upturn would
have to be repaid in the downturn - --through escrow accounts
- --tax system
- Create Public Rating Agencies
77I. Reduce Asymmetric Incentive Structures and
Moral Hazard
- 2. Implement lender-of-last-resort actions with a
sting. - Examples
- Rainmakers must be made to pay significantly when
their firms are bailed out. (reductions in pay
no golden parachutes)?
78II. Broaden and Strengthen Regulatory Reach
- 3. Extend regulatory over-sight to the shadow
banking system. - -private equity firms
- -hedge funds, etc.
- Level the playing field, and level it UP not down.
79II. Broaden and Strengthen Regulatory Reach
- 4. Restrict or eliminate off-balance sheet
vehicles. - -Move all risky investments back on bank balance
sheets and require adequate capital to support
them. Capital requirements should be sufficient
to protect bank solvency even during the
liquidity crises that occur from time to time.
80II. Broaden and Strengthen Regulatory Reach
- 5. Implement a financial pre-cautionary
principle. - Once the financial regulatory structure is
extended to all important financial institutions,
it would be possible to implement a regulatory
precautionary principle with respect to new
products and processes created by financial
innovation similar in principle to the one used
by the US Food and Drug Administration to
determine whether new drugs should be allowed on
the market.
81III. Increase Transparency
- 6. Prohibit the sale of financial securities that
are too complex to be sold on exchanges. - That is, insist that all these financial
securities be traded on organized markets. - The most complex products, including CDOs,
cannot be sufficiently simplified and would
disappear from the market.
82A general ban on OTC derivative trading has one
key advantage over attempts to prohibit specific
products such as CDOs. Investment banks can evade
regulations banning specific products or services
by creating alternative products that are not
identical, but perform the same functions.
Prohibiting OTC products would eliminate this
form of regulatory evasion.
83III. Increase Transparency
- 7. Require due diligence by creators of complex
structured financial products. -
- This task would be difficult and costly if done
properly it could make the most complex
securities unprofitable. If this could not be
done to regulators' satisfaction, sale of these
securities should be prohibited. Make securities
creators of MBSs identify particular mortgages
to help with unwindingagain will lead to less
complex securities.
84IV. Reduce Pro-Cyclicality
- 8. Restrict the growth of financial assets and
excessive leverage through counter-cyclical
capital requirements. - A key flaw in current finanical markets is it
leads to booms and busts. Putting in a system
where the ratio of capital requirements goes up
in the boom and down in the bust will work as an
automatic stabilizer.
85IV. Reduce Pro-Cyclicality
- 9. Create a bailout fund financed by Wall Street.
- For example
- -Impose a small financial transaction tax to
create a fund to engage in financial bail-outs
when necessary.
86Reform the Banking and Financial System
- V End Too big and complex to Fail
87End Too Big and Too Interconnected to Fail
- Paul Volcker reinstate Glass-Steagall
- Mervyn King Governor of Bank of England
- Prevent Banks from engaging in risky behavior
88Lord Turner Financial Services Authority
- Financial System is too big and does not serve
the real economy
89Possible tools
- Leverage and Capital Requirements
- Anti-Trust Provisions break up the finanical
systems - A New Glass-Steagall type restrictions carve off
core banking functions - Bank Act of 1940 closely related business lines
- Transactions taxes shrink size of financial
markets and raise money for good uses
90What is the Obama Administration doing?
- Appears to be making reforms but they are in fact
passing no legislation or very weakened
legislation. - Reforming Pay
- Derivatives
- Consumer Protection Consumer Finance Protection
Agency - Investor Protection
- Too big to Fail
- Comprehensive Reform
91More fundamental Reform of financial system in
the U.S.
- Return to core mission of banking and finance
- --part of mechanism to provide means of payment
(money)? - -- provide credit for real investment and
innovation - ---safe store of wealth
- --help people save for retirement
92Why so little progress?
- Dick Durban, talking about capitol hill The
Banks own the place. - Marcie Kaptor, congresswoman from Ohio There
has been a financial coup detat.
93We will not be able to enact adequate reforms
until two fundamental changes take place.
- First, the mainstream theory of efficient
financial markets that is the foundation of
support for the NFA must be replaced by the
realistic financial market theories associated
with John Maynard Keynes and Hyman Minsky.
94 Second, there must be a broad political mandate
in support of serious financial regulatory
reform.
- For too long the money from financial
institutions have corrupted the political
process.
95Thank you