Beruflich Dokumente
Kultur Dokumente
Kashif Ghani1
Abstract
This paper describes how our ideals of financial regulation failed to prevent yet another financial
crisis. It lays emphasis on the lessons we have learnt from the Global Financial Crisis (GFC)
and the realization that our new measures aimed at preventing a crisis might fail to prevent the
next crisis. It has been argued that market discipline and regulation must be balanced in a
manner that they complement each other in order to achieve the objectives of regulation. The
paper discusses the changes required to be made in the financial regulations framework that
may help reduce the likelihood and impact of future crises, the degree to which market discipline
and disclosure regime can be relied upon to achieve the objectives of regulation and the type of
crises that are likely to challenge the stability of our financial systems in future.
JEL Classification: G01, G18, G28,
Key words: Global Financial Crisis, Financial Regulation, Securities Regulation, Market
Discipline, Financial Stability, Disclosure
Kashif Ghani is Deputy Director at Securities & Exchange Commission of Pakistan (SECP). The views
expressed in this paper are the views of the author and do not represent the position of the authors
employer. Email: kashifgm105@hotmail.com
1. INTRODUCTION
The Great Recession now ranks as the most serious financial crisis we have
seen since the great depression. It has shaken publics confidence in the
financial systems considered extremely robust only a couple of years back.
The crisis brought the world financial system almost to the brink of collapse.
Financial markets were only able to continue performing their functions as a
result of expensive rescue of public sector banks.
IMFs Global Financial Stability Report (2011) point out that despite some
signs of improvement in economic growth, the global financial stability is yet
to be achieved. According to IMF, although the financial markets have shown
signs of stability, risks and challenges still remain that need to be addressed. In
advanced economies, governments continue to be indebted and the financial
institutions are struggling to recover from shocks.
Indeed the Great Recession has reminded us of many forgotten lessons. The
most important being the need to rethink our financial regulations framework.
One thing that the crisis has not changed is the basic objectives of regulation.
Even after the crisis, the objectives of securities regulation remain unchanged.
Regulators still need to focus on maintenance of investor confidence,
promoting fair and transparent markets and minimizing risks threatening the
stability of the financial system. However, much rethinking is required for
determining which tools and techniques must be employed in order to achieve
the objectives of securities regulation.
For the purposes of this paper, securities regulation is meant to include the
regulation of equities, bonds, collective investment schemes, derivatives and
other similar financial products.
Existing Literature
A large amount of literature exists on the causes of financial crises, the role of
market discipline and disclosure; on how regulation should respond to the
2|Page
financial crisis and how the financial crises have changed the way regulators
must design and implement rules and standards.
Another significant contribution was made by Poser (2009) in his study that
highlights how regulators lost sight of their basic objectives of regulation and
failed to respond to the changing market dynamics in the period leading up to
the financial crisis. Specifically, it gives a history of SEC USA, its evolving
focus over time, the debacles that are termed SECs failures and the reasons
why SEC failed to prevent two major crises in 2008. Poser (2009) argues that
the regulators were unable to prevent these crises primarily due to their
obsession with market deregulatory philosophy. He proposes that SEC USA
needs to restore its activism of the 1930s and 1960s along with keeping itself
familiar with new financial instruments and entities through in depth studies of
particular segments, activities and players in the market.
3|Page
A very important study with reference to the crisis in banking is the FSAs
report called The Turner Review (2009), which covers in great detail the
causes of global banking crisis and how bank regulators should respond to the
changing scenario after the lessons learnt from the crisis. It proposes a large
set of reforms aimed at averting a future crisis in banking, including
improvements to the capital adequacy framework, institutional and
geographical coverage of regulations, changes to the regulation of gatekeepers
(e.g. credit rating agencies) and changes in the regulators supervisory
approach, among other things. There are a number of other studies on various
areas of securities regulations, market discipline and the impact financial crisis
is likely to have on financial regulation.
meet the needs of the post crisis scenario. Section 5 gives a brief description of
the types of crises we are likely to face in the future despite our best efforts.
Section 6 concludes the discussion.
Many attempts have been made to analyze the factors and circumstances
leading up to the GFC. One theory suggests that macro imbalances played a
significant role in the factors leading to the GFC as the oil exporting countries
and Asian giants like China and Japan had huge current account surpluses in
the period leading up to the GFC and countries like UK and USA had large
current account deficits (The Turner Review, 2009). Very high saving rates
existed in countries having current account surpluses while some developed
countries like UK and USA had very low real risk free rate of interest. This
meant that in USA and UK the investment avenues promising higher expected
rates of return became very attractive for the investors. This led to an increase
5|Page
Similar views have been expressed by others such as Martin (2009) who
observes that securitization of subprime mortgages, the decline in real estate
prices, the complexity of the products that were being introduced (with
accompanying lack of information) and mark-to-market accounting issues
contributed significantly to the credit crisis.
7|Page
It is widely believed now that market discipline failed to limit risk taking
behavior of market participants within acceptable parameters during the GFC.
In the pre-crisis period disclosure framework and a set of rules were thought to
be sufficient to prevent excessive risk taking and encourage banks and other
intermediaries to act in a way that promoted confidence of their customers
(investors) in their services and in financial markets generally. Market
gatekeepers were expected to adhere to highest professional standards as their
reputations were supposed to be at stake; however, this was essentially a
simplistic view which the crisis has proved to be incorrect. Some scholars hold
that market discipline did work but its effect was too little too late to avert a
disaster. Even in that case, there would still be need for taking further steps for
strengthening the mechanics for stronger market discipline.
The regulators now face the challenge of restructuring financial markets in a
way that promotes financial stability, without compromising on efficiency.
Regulators must make efforts to limit the undesirable, destructive competition
and excessive risk taking by market participants. However, to promulgate
countless new rules and regulations in an attempt to cover every possible
aspect of the behavior of financial institutions would be inefficient as well as
ineffective. Inefficient because doing so will also require increase in the staff
required for enforcement of those rules; and inefficient because covering each
possible aspect is humanly impossible, especially in this era of financial
innovation and ingenuity. Thus such detailed rules would ultimately fail to
prevent the next crisis and all efforts in designing those detailed rules will
prove fruitless. In this context, putting in place a robust system of market
discipline is likely to prove more beneficial.
On the other hand, the idea of banning every product that is considered evil,
dangerous or vaguely suspicious for the unsuspecting investors and for the
financial markets at large, is impractical. Regulators, therefore, need to place
more emphasis on the discipline coming from within the market
(Shanmugaratnam, 2001).
8|Page
The first pillar stresses the need for availability of adequate and reliable
information on the financial performance and risk exposures of financial
institutions for making timely and informed decisions.
The second pillar underlines the need for existence of independent market
participants possessing the ability to accurately process the information and
the right incentives to monitor the risk exposures of the financial institution.
The third pillar stresses the need for existence of disciplining mechanisms/
instruments that may be used by market participants to exercise discipline or
penalize excessive risk taking. Ideally, the market should provide sufficient
solvency signals for instrument holders or creditors to demand change of
management or for the regulators to intervene.
9|Page
It is argued that many of the risk factors that eventually led to the advent of
financial crisis were disclosed in considerable detail in various documents;
however, the users of information were unable to understand the true
implications of such risk factors and the effect these were likely to have on
their investments. Even more difficult it would have been for an investor to
fully comprehend the combined effect of these factors on the financial
markets.
12 | P a g e
Regulators have been criticized for being too lenient on market intermediaries
and failing to properly deal with conflict of interest situations. They are now
faced with the task of devising regulations to address conflict of interest
situations that endanger the health of our financial system. Market
intermediaries are naturally at an advantage in terms of access to information.
Market imperfections and asymmetric information are the key reasons which
may lead the intermediaries to exploit such situations. The regulators are again
faced with the uphill task of balancing regulations as too lenient regulations
would permit exploitation by market intermediaries at the cost of their clients.
On the other hand, too harsh regulations run the risk of inhibiting growth by
disallowing activities that may otherwise be appropriate. Regulations should
ideally focus on encouraging the development of internal controls that help
control such conflicts of interest (Emerging Markets Committee of IOSCO,
2010).
Moreover, as with any set of rules and standards; the implementation and strict
enforcement of laws is as important from regulatory point of view as the
regulations themselves. Regulators also need to develop required capabilities
and technical expertise to carry out investigations and take effective
enforcement action with reference to COI situations. Rules and regulations
should be primarily aimed at changing the behavior of firms concerned as
avoidance of COI situations inevitably involves exercise of best judgment by
the management of these intermediaries. As conflict of interest situations can
take many different forms; it is practically not possible to devise a set of rules
for each type of COI situation. Thus rules should be targeted at developing
higher level rules for guiding the behavior of management of financial
intermediaries, combined with strong monitoring by the regulators. The
methodology to be adopted by the regulators may include encouraging firms
to engage senior management of the entities in the decisions involving COI
situations.
13 | P a g e
4.
i)
Principles based regulations (PBR) are the need of the time. Principles based
regulations means broad set of standards focusing on the final goal to be
achieved rather the mechanics of it. These standards would be aided by set of
guidelines on how to achieve the desired outcomes. PBRs mean focusing less
on chalking out detailed rules and prescriptions on how firms should operate.
Instead the PBR give the firms more independence to operate within the set
regulatory principles.
Principles based regulations are preferable over the more detailed rule based
regulations on the grounds that prescriptive standards have not been effective
in complete prevention of market misconduct (Committee on Capital Markets
Regulation, 2009). Detailed rules and regulations are burdensome for the
regulators to devise and cumbersome to follow for the regulated entities.
Detailed rules also fail to capture the changing nature of the financial sector
and regulations often struggle to keep pace with innovations in products and
range of services offered. Regulations based on principles are more likely to
create an environment conducive to such innovations and advancements. The
expectation that rules and regulations would always keep pace with these
innovations is unrealistic and is likely to create hindrance to novelty in
products and services. As the complexity of financial market and products
increases, so will the complexity of rules to be followed.
14 | P a g e
Detailed rules and regulations make compliance more difficult especially for
the smaller companies that lack dedicated resources having expertise in legal
and regulatory matters (The Financial Services Authority, 2007). Sometimes
elaborating such details may also have negative effect of both regulator and
the regulated entity being engrossed in ensuring compliance with the law in
letter, but unable to follow its true spirit.
However, it must be understand that this shift of focus does not mean
complete elimination of rules and regulations. There will always be need for
detailed rules in some areas which will be required to be in place. This
approach aligns well with the participatory role of the regulator as it makes
following the law less cumbersome for the regulated entities.
ii)
15 | P a g e
The recent financial crisis has indeed exposed the credit, operational and
systematic risks inherent in an unregulated CDS market. Some of these
inherent risks can be mitigated by making CDS instruments subject to
centralized clearing.
Regulations directed towards managing systemic risks must take into account
behavioral factors that lead market players to take decisions that would not
pass the test of rationality. Behavioral biases lead individuals to make errors of
judgment regarding the risks involved in their investments thus contributing to
enhanced systemic risk. Encouraging companies to provide their risk
managers with reasonable degree of independence and authority to question
excessive risk taking behaviors by decisions makers is one way of handing this
problem. Furthermore, companies may be encouraged to perform qualitative
analysis of risks, in addition to the use of quantitative models.
Agency problems lead managers to take excessive risks or the risks that
shareholders do not want the company to undertake. Regulators can play their
part by encouraging companies to align executives remuneration with
companys long-term performance. Furthermore, regulators must also consider
the ability and willingness of market participants to appreciate risks inherent
in their investments. Complex financial products sometimes make it difficult
for decision makers to fully appreciate the risks involved in their investments.
This leads to enhanced threat to the stability of the financial system.
iii)
16 | P a g e
iv)
Other considerations
The regulators need to re-adopt the policy of active regulation with strong
regulations focusing on investor protection and market stability. Regulators
must keep themselves abreast of developments taking place in the financial
markets, train and equip their staff members to better regulate complex and
innovative financial products being introduced from time to time. Regulators
need to strike the right balance between promoting growth of financial
markets and achievement of market discipline and stability. The staff members
at the securities regulators must be provided proper training along with a
career path that incentivizes them to pursue a long term career with the
regulator. This will reduce likely conflicts of interest caused by the fact that
market participants could be possible future employers for staff members. This
may also mean grooming of staff members and preparing them for
appointment at senior most positions (e.g. Commissioners) in the regulatory
bodies.
It has also been proposed that in order to achieve the goal of investor
protection; the regulators should consider aiming to dissuade unsophisticated
investors from investing directly in the security markets (instead encourage
investment through mutual funds). This may done, for instance, by including a
disclaimer similar to ones given by mutual funds, in the broker contract that
investing directly in securities markets involves considerable risk and is
suitable for well knowledgeable investors only (Zingales, 2009). This will
allow regulators to focus more on asset managers and mutual funds and
possibly eliminate the need for detailed rules intended to protect unsuspecting
individual investors. Removal of some of the tedious rules may also encourage
more companies to offer their securities to the market.
18 | P a g e
Price bubbles have been at the forefront of many of the crises in recent times
and excessive risk taking and herd mentality will probably continue to produce
price bubbles in years to come. Gerding (2006) has done extensive work on
the financial crises, price bubbles and on the decay of securities regulations.
His argument revolves around two basic premises. First, a period of financial
growth generally creates or strengthens political pressure in the favor of a
framework inclined towards deregulation. In a period of financial growth
culminating in a bubble, market players lobby for less stringent securities laws
citing prevailing financial stability and growth. Rules and regulations
restricting excessive risk taking are portrayed as impediments to the growth of
the financial sector. Thus policy makers are persuaded to consider diluting
securities regulations with an aim to promote growth. The resistance by
market participates may also include resistance against new proposals that
address excessive speculation and risk taking. A period of growth and relative
financial stability thus becomes non-conducive to imposition of limits on the
risk taking of institutions. Secondly, bubbles tend to enfeeble even those
regulations that remain unaffected by political pressures. This can be caused
by several factors, including increased work load and pressures to finalize
impending deals - performance pressures that may lead to industry wide
decline in professional norms and weakening status of compliance with laws
and rules.
Financial institutions and their managers are under pressure during periods of
sustained economic growth to report profits, comparable or better than
competition. These performance pressures lead managers to assume excessive
risks in anticipation of higher profits which results in greater systemic risks.
Managers unable to keep pace with competition are considered underperformers and often end up getting below par remuneration. Companies that
succumb to this performance pressure often expand at a faster pace using
higher leverage. This works without much trouble during the periods when
asset prices are on the rise, stock markets are performing well and there are
few defaults on the bond market with sufficient liquidly in the system.
However, as the boom nears its end, liquidity dries up especially for highly
leveraged firms who have already started experiencing higher defaults partly
due to lower standards of credit assessments used during the period of
aggressive growth. Thus booms and busts follow each other in a cycle and
prohibiting the use of particular products would do little to prevent the next
crisis (Goodhart, 2009).
Liquidity, credit and banking crises might continue to occur every now and
then in one part of the world causing trouble elsewhere in this increasingly
interconnected financial world. The task for regulators is tough as they battle
to find the right policy response to these recurring crisis situations.
20 | P a g e
6. CONCLUSION
Securities markets regulations can greatly benefit from the increasing
emphasis and focus on relevant research. Regulatory authorities need to
realign their research budgets so that in-depth research on the issues affecting
the stability of our financial system is conducted and appropriate policy
recommendations are formulated. Dedicated human resources specializing in
research on regulations and policy issues should be developed for this purpose.
The recommendations from these researchers should be given due weight-age.
One of the lessons learned from the financial crises experience over the years
is that regulators must discontinue being over-reactive to market events.
Sarbanes Oxley Act was enacted in 2002 in response to major corporate
scandals such as Enron and Worldcom. Checks on executive remuneration
were introduced immediately after expensive bailouts of troubled banks; and
there have been calls for complete banning of CDS after credit crisis. Far from
commenting on the merit of some of these actions, this paper argues that
regulators need to stick to the principles of regulations during the periods of
growth and during crises, rather than being lax during a bubble and overstringent after a bust.
As suggested by Barr et al (2009); regulations must be behaviorally
informed. Regulators must consider the limitations of disclosure and market
discipline due to behavioral factors and the design of all future policies should
take into account the complex mix of rational choice and behavioral biases
which inherently reduce the predictability of these regulatory choices. Policy
makers must have the realization that market players do not always act in their
own interest (i.e. due to complexity, complacency and conflict as suggested by
Anabtawi and Schwarcz, 2011). Thus market players cannot be expected to,
automatically take into account the collective interest of the whole market.
21 | P a g e
This is due in part their inability to see the complete picture (as also suggested
by Gorton (2009)).
22 | P a g e
References
Allen, F. and Gale, D. (1999); Bubbles, Crises and Policy; Oxford Review of
Economic Policy; Vol. 15, No.03
Alliance for Liberals and Democrats for Europe (ALDE) (2008); Workshop
titled International Financial Crisis: Its causes and what to do about it;
Liberals and Democrats Workshop, February 27th, 2008
Anabtawi, I. and Schwarcz, S. L. (2011); Regulating Systemic Risk: Towards
An Analytical Framework; Duke Law Faculty Scholarship; Paper 2305.
http://scholarship.law.duke.edu/faculty_scholarship/2305 (accessed on May
12, 2011)
Avgouleas, E. (2009); What Future for Disclosure as a Regulatory Technique?
Lessons from the Global Financial Crisis and Beyond; Available at:
http://ssrn.com/abstract=1369004 (accessed on May 19, 2011)
Barr, M.S., Mullainathan, S. and Shafir, E. (2009); The Case for Behaviorally
Informed Regulation, in New Perspectives In Regulation; David Moss & John
Cisternino ed. 2009.
Bordo, M.D. (2007); Growing Up To Financial Stability; Working Paper
12993,
March
2007;
JEL
No.
N00,
N2
(available
at
Available
at:
plan
for
regulatory
reform;
available
at:
http://www.capmktsreg.org/pdfs/TGFC-CCMR_Report_(5-26-09).pdf;
accessed on May 19, 2011)
Crockett, A. (2001), Market Discipline and Financial Stability, BIS
speeches,
23
May
2001
(Available
at:
accessed
on:
Perspective,
(9
July
2010);
Available
at:
http://www.asic.gov.au/asic/pdflib.nsf/LookupByFileName/RethinkingSecuriti
esRegulation-20100709.pdf/$file/RethinkingSecuritiesRegulation20100709.pdf; (accessed on May 11, 2011)
Gerding, E.F. (2006); The Next Epidemic: Bubbles and the Growth and Decay
of Securities Regulation; (February 2006); Connecticut Law Review 38(3), pp.
393-453
Goodhart, C, et al (2009), The Fundamental Principles of Financial
Regulation, Geneva Reports on the World Economy 11; (available at:
www.princeton.edu/~markus/research/papers/Geneva11.pdf;
accessed
on:
Gorton, G. (2009); Slapped in the Face by the Invisible Hand: Banking and the
Panic
of
2007
(May
09,
2009);
available
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1401882;
accessed
at:
on:
2011);
(available
at:
Crisis;
(January
7,
2009)
(available
at:
Finance,
Vol.
36,
No.
1,
2011;
available
at:
http://ssrn.com/abstract=1667824
25 | P a g e
on
the
outcomes
that
matter;
(Available
at:
(available
at:
www.fsa.gov.uk/pubs/other/turner_review.pdf;
26 | P a g e
(available
at:
27 | P a g e