A Financial Pre-Cautionary Principle: New Rules for Financial Product Safety Gerald Epstein Department of Economics and Political Economy Research Institute

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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 IDEAS Conference Chennai, India January 24 27, 2010 Slide 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.eduwww.peri.umass.edu Slide 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 Slide 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 Slide 5 Slide 6 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. Alan Greenspan Testimony, 23/10/08 Slide 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 Slide 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. Slide 9 Source: Reinhart and Rogoff, 2008a Longer Term Perspective 1900 -2008 Current Crisis Slide 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 Slide 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 Slide 12 Essence of the New Financial Regulatory System 1.Self-Regulation 1.Outsourcing Regulation 1.Ineffective public regulation of only some of the financial sector Slide 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. Slide 14 Outsourcing Regulation to Gate- Keepers 1.Bond ratings agencies (Moodys, Standard and Poors, Fitch) 1. Accounting firms Slide 15 Ratings agencies 1.Key problem: conflict of interests 1.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 Slide 16 Creation of Un-regulated Shadow Banking System Over the Counter (OTC) Derivatives Markets Hedge Funds Private Equity Funds Slide 17 De-Regulation led to: New Financial Architecture: Originate and Distribute Model Slide 18 STRUCTURAL FLAWS IN THE NFA POWERED THE BOOM, CAUSED THE CRISIS AND MUST BE FIXED Structural Flaws In The New Financial Architecture (NFA) Slide 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 Slide 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. Slide 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. Slide 22 NFA: Flaw 4 A system that was at root pro-cyclical in its dynamics and led to excessive leverage. Slide 23 NFA: Flaw 5 The Financial System was too big, too complex and too inter-connected to understand and to fail. Slide 24 Led to banking systems that are impaired or insolvent Slide 25 Focus now on one aspect The Regulation of New Financial Products Slide 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 Slide 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 Slide 28 Complex and Opaque Products 1.Spread throughout the system in US and abroad 2. Led to crisis of confidence 3. Led to liquidity crises Slide 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. Slide 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 Slide 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.moralpolitical principle publicenvironment scientific consensusburden of proof Slide 32 Several Analysts have proposed that new financial products be approved Joseph Stiglitz George Soros Daniel McFadden Martin Hellwig Others. Slide 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 Slide 34 There are precedents: 1.Malaysia 2.India 3.Spain 4.Earlier precedents in the U.S. and Europe Slide 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 Slide 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. Slide 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. Slide 38 With respect to new financial markets: They must always get permission. Slide 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. Slide 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 Slide 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 ) Slide 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. Slide 43 More Capital required for structured products: More capital has to be held by the originator for complex structured products. Slide 44 Liberalization Many of these provisions are now being liberalized Slide 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. Slide 46 Create New Authority Use Indian lessons, but create new authority with the objective and culture designed specifically to tackle this problem. Slide 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: 1.Pre-Marketing Evaluation 1.Post-Marketing Enforcement, regulation and re- evaluation Slide 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. Slide 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. Slide 50 FSPSA For example: They might only be able to be sold on a limited basis to certain kinds of institutions Those buyin