A Financial Pre-Cautionary Principle: New Rules for Financial Product Safety

Gerald EpsteinDepartment of Economics and Political Economy Research Institute (PERI)

University of Massachusetts, AmherstUSA

IDEAS ConferenceChennai, India

January 24 – 27, 2010

Joint Work with James CrottyBased 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

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

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”

“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

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”

“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. “…that’s 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.”

Source: Reinhart and Rogoff, 2008a

Longer Term Perspective1900 -2008

Current Crisis

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

New Deal System of financial Regulation Eroded in the U.S. in the 1970’s, and 80’s

Largely due to pressure from large banks and their allies in the Fed, Treasury,

Congress and the White House

Essence of the New Financial Regulatory System

1. Self-Regulation

1. Outsourcing Regulation

1. Ineffective public regulation of only some of the financial sector

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.

Outsourcing Regulation to Gate-Keepers

1. Bond ratings agencies (Moodys, Standard and Poors, Fitch)

1. Accounting firms

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

Creation of Un-regulated Shadow Banking System

• Over the Counter (OTC) Derivatives Markets

• Hedge Funds

• Private Equity Funds

De-Regulation led to:

New Financial Architecture: Originate and Distribute Model

STRUCTURAL FLAWS IN THE NFA POWERED THE BOOM,

CAUSED THE CRISIS AND MUST BE FIXED

Structural Flaws In The New Financial Architecture (NFA)

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 didn’t lose on the way down

Credit Rating agencies – paid to give over-optimistic ratings

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.

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.

NFA: Flaw 4

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

NFA: Flaw 5

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

Led to banking systems that are impaired or insolvent

Focus now on one aspect

The Regulation of New Financial Products

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

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”

Complex and Opaque Products

1. Spread throughout the system in US and abroad

2. Led to crisis of confidence

3. Led to liquidity crises

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 system’s 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.

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

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.

Several Analysts have proposed that new financial products be approved

• Joseph Stiglitz

• George Soros

• Daniel McFadden

• Martin Hellwig

• Others….

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”

There are precedents:

1. Malaysia2. India3. Spain4. Earlier precedents in the U.S. and Europe

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

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.

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.

With respect to new financial markets:

They must always get permission.

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.

Examples:

Only certain, plain vanilla derivatives are allowed:

• Forwards• Interest rate swaps• Interest rate futures

• Structured Products cannot contain derivatives that are otherwise prohibited

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 )

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.

More Capital required for structured products:

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

Liberalization

Many of these provisions are now being liberalized

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.

Create New Authority

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

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

Financial Stability and Product Safety Administration (FSPSA)

• Stresses that the main concern is the impact of financial products on over-all financial stabilityas 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.

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.

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.

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

Possible Objections to the Financial Stability and Product Safety Administration

1. 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”

Most of these objections can be answered

1. 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

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.

Regulatory Capture

A serious potential problem. Only solution is serious democratic transparency and accountability.

This includes: getting money OUT OF politics.

Characteristics of High Risk Products are well known to bankers themselves

1. They embody high leverage (note: these are embodied in products and not just institutions)

1. They are prone to periods of large and rapid reductions in market liquidity

1. They lack price transparency

1. Often subject to maturity mismatches in funding

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

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

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

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.

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.

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

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

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

Only some reflect increases in efficiency.

312580

Finnerty and Emery, 2002

342165Finnerty, 1992

4445103Finnerty, 1988

Percentage of total

innovations motivated by

tax or regulatory reasons

(2)/(1) x 100(%)

Number motivated at

least partly be tax or regulatory

reasons(2)

Total Number of Security Innovations

(1)

Study

Motivations for Financial InnovationFinnerty Studies

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 menu…not opportunities for speculation and financial arbitrage."

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”.

Other issues:

Financial Patents –

recently became legal (State Street Case, in the U.S.)

so far, not very important; don’t led to more R&D; perhaps FSPSA will lead to greater importance

Regulatory Capture

More Serious Problem:

1. Need Community Oversight Boards: oversight of FSPSA

1. Truly independent academic experts to serve on testing and monitoring boards

3.More objective academic research on financiai product impacts and testing

Academic Capture

1. Big Problem in this area (as with scientists and drug testing)

1. Many “finance” academics work part-time for financial firms, get grants from them and/or are owners of such firms.

1. Makes it difficult to get truly independent analysis about the effectiveness and riskiness of financial products.

Lawrence Summers

A partner of D.E. Shaw: a major hedge fund and also an Economics Professor at Harvard.

(Now Obama’s chief economic advisor)

Avoiding Academic Capture

1. FSPSA: well paid positions for financial economists

1. Research Grants/Post Docs for young economists

1. High Quality Refereed Journals for young economists working in these areas

2. Presigious academic conferences to present work3. Help Re-enforce ethics rules at Universities on

conflicts of interest.

What about reforming the financial sector more generally?

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.

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

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)

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.

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.

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.

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.

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.

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 MBS’s identify particular mortgages to help with unwinding…again will lead to less complex securities.

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.

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.

Reform the Banking and Financial System

V: End Too big and complex to Fail

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

Lord Turner: Financial Services Authority

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

Possible tools

1. Leverage and Capital Requirements

1. Anti-Trust Provisions: break up the finanical systems

1. A New Glass-Steagall type restrictions: carve off core banking functions

1. Bank Act of 1940: closely related business lines

1. Transactions taxes: shrink size of financial markets and raise money for good uses

What is the Obama Administration doing?

Appears to be making reforms but they are in fact passing no legislation or very weakened legislation.

1. Reforming Pay2. Derivatives3. Consumer Protection: Consumer Finance Protection

Agency4. Investor Protection5. Too big to Fail6. Comprehensive Reform

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

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 d’etat”.

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.

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.

Thank you