A Failure to Regulate and the Financial Crisis

This post concerns a topic outside of the usual focus of this blog - namely, the regulation of finance.  This is a subject of intense interest over the past few weeks after the creation of a Fannie Mae and Freddie Mac government conservatorship and thecollapse of Lehman Brothers.

The current financial crisis illustrates how a national government’s regulation of commercial activity can impact the world’s economic health. Quoting Nouriel Roubini in the 2008 Financial Development Report by the World Economic Forum: "[i]n short, a systemic financial crisis is a sign of the failure of the financial system, the failure of appropriate risk management, and the failure of proper corporate governance."

The magnitude of the current crisis will, of course, not be limited to the U.S.  Other central banks have made major efforts to mitigate the impact of poisonous assets circulating throughout global financial markets. As an aside, the BRIC countries have been notably absent.  An editorial in last week's Financial Times by columnist Philip Stephens notes that national governments are “left with responsibility” for their failure to implement preventative regulation and are “without power” to do something about it. “Governments need to find ways to reclaim some of the sovereignty lost to globalisation. That means more global governance: credible international rules.”

To provide a specific example of how inadequate regulation enabled the current crisis, consider capital adequacy ratios. A capital adequacy ratio is the ratio of a bank’s capital to risk-weighted assets. The Basel Committee on Banking Regulation and Supervisory Practices, an international advisory body, provides standards that provide general guidelines on capital adequacy ratios. National governments are then encouraged to implement these guidelines. The Basel II Accord provides for a framework that gives banks various means to determine their risk exposure. Among them is the use of third-party credit rating agencies who determine the value of a bank’s risk-weighted assets.

Moreover, the Basel II regulatory world is the reliance on credit rating agencies to determine risk associated with leveraged assets with little in the way of regulation governing these agencies is a contributing factor to the current crisis. Alan Greenspan mentioned in an interview with a German paper in 2007 that these credit agencies mispriced credit risk and the market, unfortunately, believed their ratings. Moreover, national regulators failed to implement capital adequacy ratios on exchange-traded derivatives. As evidenced by Lehman Brothers’ collapse, the risk associated with these assets was never adequately priced and many other firms are and will be exposed to their unwinding. 

In Global Governance of Financial Systems: the International Regulation of Systemic Risk,  Kern Alexander, Rahul Dhumale, and John Eatwell present five specific guidelines for the international financial regulators dealing with the problem of systemic risk in globalized financial markets.  First, regulators must increase financial heterogeneity.  This may be done by creating a regulatory body “with the powers to develop [a] flexible structure of rules and rule making.”  Additionally, the Authors argue this body should have broad enforcement and monitoring powers.  Second, there should be an international lender of last resort.  However, the moral hazard associated with “liquidity without strings” must be tempered by “powerful rules on risk taking.”  Third, a “new financial architecture should encompass macroeconomic concerns.”  Fourth, the regulators’ rules “need to make greater use of the new work on extreme, rare events.”  Fifth, the scope of the regulators’ activity should be the international market itself.  I published a review of  this book last year. 

The case for stronger international financial regulation has never been more persuasive.

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[Wade Henderson]

Islam and Finance
http://immfinancial.com/2011/islam-finance/

Global finance today dominates the world economy. Western economies are characterized with financial sectors which generate billions for the economy. Stock Markets, multinationals, companies raising billions, initial public offerings (IPO) and so on, all symbolize the apparent success of Capitalism. Finance is important in any economy for two fundamental reasons...