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 - PowerPoint PPT Presentation

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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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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


1
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

2
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

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
4
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

5
(No Transcript)
6
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.

7
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

8
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.

9
Longer Term Perspective 1900 -2008
Current Crisis
Source Reinhart and Rogoff, 2008a
10
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

11
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

12
Essence of the New Financial Regulatory System
  • Self-Regulation
  • Outsourcing Regulation
  • Ineffective public regulation of only some of the
    financial sector

13
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.

14
Outsourcing Regulation to Gate-Keepers
  • Bond ratings agencies (Moodys, Standard and
    Poors, Fitch)?
  • Accounting firms

15
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

16
Creation of Un-regulated Shadow Banking System
  • Over the Counter (OTC) Derivatives Markets
  • Hedge Funds
  • Private Equity Funds

17
De-Regulation led to
  • New Financial Architecture Originate and
  • Distribute Model

18
Structural Flaws In The New Financial
Architecture (NFA)?
  • STRUCTURAL FLAWS IN THE NFA POWERED THE BOOM,
    CAUSED THE CRISIS AND MUST BE FIXED

19
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

20
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.

21
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.

22
NFA Flaw 4
  • A system that was at root pro-cyclical in its
    dynamics and led to excessive leverage.

23
NFA Flaw 5
  • The Financial System was too big, too complex and
    too inter-connected to understand and to fail.

24
Led to banking systems that are impaired or
insolvent
25
Focus now on one aspect
  • The Regulation of New Financial Products

26
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

27
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
28
Complex and Opaque Products
  • Spread throughout the system in US and abroad
  • 2. Led to crisis of confidence
  • 3. Led to liquidity crises

29
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.

30
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

31
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.

32
Several Analysts have proposed that new financial
products be approved
  • Joseph Stiglitz
  • George Soros
  • Daniel McFadden
  • Martin Hellwig
  • Others.

33
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

34
There are precedents
  1. Malaysia
  2. India
  3. Spain
  4. Earlier precedents in the U.S. and Europe

35
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

36
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.

37
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.

38
With respect to new financial markets
  • They must always get permission.

39
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.

40
Examples
  • Only certain, plain vanilla derivatives are
    allowed
  • Forwards
  • Interest rate swaps
  • Interest rate futures
  • Structured Products cannot contain derivatives
    that are otherwise prohibited

41
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 )?

42
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.

43
More Capital required for structured products
  • More capital has to be held by the originator for
    complex structured products.

44
Liberalization
  • Many of these provisions are now being liberalized

45
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.

46
Create New Authority
  • Use Indian lessons, but create new authority with
    the objective and culture designed specifically
    to tackle this problem.

47
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

48
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.

49
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.

50
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.

51
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

52
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

53
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

54
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.

55
Regulatory Capture
  • A serious potential problem. Only solution is
    serious democratic transparency and
    accountability.
  • This includes getting money OUT OF politics.

56
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

57
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

58
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

59
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

60
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.

61
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.

62
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

63
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

64
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

65
Only some reflect increases in efficiency.
66
Motivations for Financial Innovation Finnerty
Studies
67
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."

68
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.

69
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

70
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

71
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.

72
Lawrence Summers
  • A partner of D.E. Shaw a major hedge fund and
    also an Economics Professor at Harvard.
  • (Now Obamas chief economic advisor)?

73
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.

74
What 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.

76
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

77
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)?

78
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.

79
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.

80
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.

81
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.

82
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.
83
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.

84
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.

85
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.

86
Reform the Banking and Financial System
  • V End Too big and complex to Fail

87
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

88
Lord Turner Financial Services Authority
  • Financial System is too big and does not serve
    the real economy

89
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

90
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

91
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

92
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.

93
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.

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.

95
Thank you
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