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

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A 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

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Joint 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

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"The world is on the edge of the abyss because of
an irresponsible system" French Prime Minister,
Francois Fillon, Financial Times, October 3, 2008
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Causes 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

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Alan 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.

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Alan 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

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In 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.

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Longer Term Perspective 1900 -2008
Current Crisis
Source Reinhart and Rogoff, 2008a
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In 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

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New 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

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Essence of the New Financial Regulatory System

• Self-Regulation
• Outsourcing Regulation
• Ineffective public regulation of only some of the
  financial sector

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Self-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.

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Outsourcing Regulation to Gate-Keepers

• Bond ratings agencies (Moodys, Standard and
  Poors, Fitch)?
• Accounting firms

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Ratings 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

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Creation of Un-regulated Shadow Banking System

• Over the Counter (OTC) Derivatives Markets
• Hedge Funds
• Private Equity Funds

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De-Regulation led to

• New Financial Architecture Originate and
• Distribute Model

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Structural Flaws In The New Financial
Architecture (NFA)?

• STRUCTURAL FLAWS IN THE NFA POWERED THE BOOM,
  CAUSED THE CRISIS AND MUST BE FIXED

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Five 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

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NFA 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.

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NFA Flaw 3

• Financial innovations that led to assets that
  were murky and opaque (non-transparent and
  complex)?
• This is the focus of this paper.

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NFA Flaw 4

• A system that was at root pro-cyclical in its
  dynamics and led to excessive leverage.

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NFA Flaw 5

• The Financial System was too big, too complex and
  too inter-connected to understand and to fail.

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Led to banking systems that are impaired or
insolvent
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Focus now on one aspect

• The Regulation of New Financial Products

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The 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

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According 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
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Complex and Opaque Products

• Spread throughout the system in US and abroad
• 2. Led to crisis of confidence
• 3. Led to liquidity crises

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Complex 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.

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Such 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

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Definition 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.

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Several Analysts have proposed that new financial
products be approved

• Joseph Stiglitz
• George Soros
• Daniel McFadden
• Martin Hellwig
• Others.

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No 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

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There are precedents

1. Malaysia
2. India
3. Spain
4. Earlier precedents in the U.S. and Europe

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Indian Example

• Reserve Bank of India (RBI)?
• Governor Y.V Reddy
• Was the Devil
• Now
• He is the Hero who Saved the Indian Financial
  System

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RBI 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.

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Products 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.

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With respect to new financial markets

• They must always get permission.

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New 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.

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Examples

• Only certain, plain vanilla derivatives are
  allowed
• Forwards
• Interest rate swaps
• Interest rate futures
• Structured Products cannot contain derivatives
  that are otherwise prohibited

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Structured 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 )?

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Unique, 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.

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More Capital required for structured products

• More capital has to be held by the originator for
  complex structured products.

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Liberalization

• Many of these provisions are now being liberalized

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Approaches 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.

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Create New Authority

• Use Indian lessons, but create new authority with
  the objective and culture designed specifically
  to tackle this problem.

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Build 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

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Financial 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.

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FSPSA

• 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.

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FSPSA

• 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.

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Post-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

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Possible 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

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Most 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

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Financial 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.

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Regulatory Capture

• A serious potential problem. Only solution is
  serious democratic transparency and
  accountability.
• This includes getting money OUT OF politics.

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Characteristics 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

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Pre-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

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Problems 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

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Stress 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

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Marginal 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.

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Main 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.

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Product 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

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Pro-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

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Will 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

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Only some reflect increases in efficiency.
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Motivations for Financial Innovation Finnerty
Studies
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James 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."

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Empirical 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.

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Other 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

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Regulatory 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

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Academic 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.

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Lawrence Summers

• A partner of D.E. Shaw a major hedge fund and
  also an Economics Professor at Harvard.
• (Now Obamas chief economic advisor)?

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Avoiding 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.

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What about reforming the financial sector more
generally?
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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.

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I. 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

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I. 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)?

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II. 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.

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II. 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.

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II. 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.

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III. 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.

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A 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.
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III. 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.

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IV. 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.

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IV. 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.

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Reform the Banking and Financial System

• V End Too big and complex to Fail

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End 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

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Lord Turner Financial Services Authority

• Financial System is too big and does not serve
  the real economy

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Possible 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

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What 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

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More 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

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Why 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.

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We 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.

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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.

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Thank you