How significant were regulatory failings in precipitating the crisis?

The financial crisis of 2007-2008 was global with consequences felt throughout the world. Obviously international regulators failed to prevent the crisis, but did their failures precipitate the crisis? When the global financial crisis exploded, it exposed gaping holes in the effectiveness of international financial regulation. There were many failures, some avoidable, others unavoidable. These failings did not cause the financial crisis, but they contributed to it. There is much room for improvement in international regulation, but we must be realistic as to its responsibilities and its capacities. International regulators failed in two ways. The first failure lies in the errors made in the exercise1 of their powers, or, human error. Regulators failed to identify the systemic risk in the financial market. This was partially due to free market ideology, that it was not the regulators place to substitute his judgment for that of the market.2 In addition, regulators assumed that markets were efficient and therefore complex trading risk was positive for the financial market.3 These are both errors made in the exercise4 of powers of international regulators. The second failure has two parts, both stemming from failings which arose from weaknesses in the powers accessible to the regulators.5 First, since international regulators lack the means to enforce regulations, regulators are inherently handicapped. Countries cannot be forced to follow the regulations. The United States never committed to Basel II, the regulatory standards preceding the financial crisis. International regulators lack of power is a fundamental weakness for which they cannot necessarily be blamed. However, the second part, structural weakness in the regulatory system itself, was avoidable. The international regulatory system lacks a hierarchy.6 The fragmentation of the International Financial Institutions (IFI) contributed to the fact that regulators were not able to see the overall weaknesses culminating into the global financial crisis.7 The regulatory body responsible for harmonizing the IFIs was the Financial Stability Forum (FSF). The FSF was established in the wake of the Asian Financial Crisis, created in order to improve and support a stable international financial market. Though there were calls for serious changes in international regulation, countries did not want to yield financial sovereignty. In the end, the FSF was only given modest power. However, it performed a number of useful functions. It produced reports assessing important financial issues; it published country vulnerability assessments, and it facilitated dialogue between country regulators.
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Ibid, p. 3 Davies, Howard: The Financial Crisis and the Regulatory Response: An Interim Assessment, p. 2 Ibid, p. 3 Ibid, p. 3 Ibid, p. 2 Davies, Howard: The Financial Crisis and the Regulatory Response: An Interim Assessment, p. 4 Ibid, p. 3

Still, the FSF has fallen short of its ambitious aims.8 Howard Davies explains its objectives as assessing vulnerabilities affecting the international financial system, identifying and overseeing action needed to address these vulnerabilities, and improving co-ordination and information exchange among the various authorities responsible for financial stability.9 At the time of the financial crisis, the regulatory standards were set by the Basel II accords. Basel II advocated a three-pillar approach to financial regulation. The first pillar imposed minimum capital requirements. These capital requirements were determined by the risk of the banks assets. The second pillar was a supervisory review, which assessed how well banks carried out risk management. The third pillar advocated stricter rules on disclosure and transparency.10 In light of the 2008 global financial crisis, it is clear that international financial regulators did not adequately prevent systemic risk.11 In fact, the systemic risk arguably arose due to improperly designed prudential regulatory standards, especially in relation to capital, liquidity, and leverage.12 In order to prevent a systemic financial crisis, according to Douglas W. Arner, the regulatory system should address four core elements. First, the regulatory system should have a robust financial infrastructure,13 that must be monitored and maintained to ensure stability. It is widely claimed that the contemporary financial system is so complex that the pre-existing ideas of regulation are out of date. New financial instruments have been developed, and regulation does not address them. Securitized Investment Vehicles (SIVs) were even created in order to circumvent accounting rules and capital regulations.14 Second, the regulatory system should provide ground rules and incentives to improve corporate governance and risk management systems.15 A major failing in risk management was the fact that financial institutions had incentive structures that encouraged their employees to do risky financial transactions. Also, under Basel II financial institutions were allowed to evaluate risk using credit rating agencies. Since the financial institutions themselves paid the credit rating agencies, there were fundamental conflicts of interest. Third, regulators must demand disclosure from financial institutions about the nature of the institutions practices and financial products. This information is essential because regulators must understand the interlinkages across markets, institutions and products.16 Shadow banking goes to the core of the transparency problem, and financial regulators failed to control it. They also did not handle the practice of regulatory arbitrage. In addition, certain highly complex instruments made transparency very difficult. Since Collateralized Debt Obligations (CDOs) were fundamentally
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Ibid, p. 116 Davies, Howard: Global Financial Regulation, p. 114 Ibid, p. 43 Adaptation and Resilience in Global Financial Regulation. Douglas W. Arner, p. 103 Ibid, p. 107 Ibid, p. 104 Davies, Howard: The Financial Crisis: Who is to Blame? p. 47 Adaptation and Resilience in Global Financial Regulation. Douglas W. Arner, p. 103 Adaptation and Resilience in Global Financial Regulation. Douglas W. Arner, p. 105

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non-transparent instruments, when the risks of sub-prime mortgage sparked fear in the market, no one knew where the risks were. The uncertainty about who was most exposedcreated a liquidity crisis in the market as a whole.17 The liquidity crisis then led to a credit crunch. Fourth, regulators must practice prudential regulation, meaning they should provide minimum requirements for safety and soundness of individual financial institutions, markets and essential infrastructure.18 Regulators made many errors in prudential regulation. One problem was that the capital requirements under Basel II were not high enough. The president of Deutsche Bundesbank, Axel Weber, explained the crisis revealed that the overall level of capital that banks were required to hold was insufficient compared with the magnitude of the losses.19 International regulators believed that the level of capital in the market was appropriate, and that their role was in regulating capital distribution. Further, Basel II did not focus enough on the quality of capital that banks were required to hold. Exasperating matters more, banks based their capital needs on the level of capital they had needed in past years. Prior to the financial crisis, banks had needed a relatively low amount of capital.20 Calculating capital needs in such a pro-cyclical way made the credit crunch exponentially worse.21 There were many regulatory failings preceding the global financial crisis. These failings, either due to human error or structural weakness, certainly precipitated the crisis. It is also true that regulators were ill prepared for the crisis, and [their] inconsistent response added to the uncertainty and panic in the financial markets.22 Failed regulations contributed to the weaknesses in the financial system, but there are other actors at fault. Loose monetary policy was very important in causing the financial crisis. Howard Davies argues that the monetary authorities on both sides of the Atlantic focused attention on retail price inflation.23 In doing so, they neglected to look at other factors of financial stability. Therefore, the dangerous risks financial institutions took occurred in that environment, and the incentive structures within financial firms pushed them to take on greater risks.24 In addition, many argue that global imbalances between surplus countries and countries with high debt levels played a role in destabilizing the financial system. Howard Davies says that these global imbalances combined with relatively loose monetary policy, created the conditions in which leverage expanded rapidly.25 International financial regulation failed to prevent the global financial crisis. This is due to errors in judgment, ideology, and lack of means. The mistakes international regulators made could certainly be accused of precipitating the financial crisis. However, international financials regulator
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Davies, Howard. Financial Regulation: Who is to Blame? p. 47 Adaptation and Resilience in Global Financial Regulation. Douglas W. Arner, p. 104-105 Davies, Howard: Who to blame? Axel weber speech quotation, p.37 Davies, Howard: Who is to Blame? p. 37-38 Davies, Howard: Who is to Blame? p. 37-38 Adaptation and Resilience in Global Financial Regulation. Douglas W. Arner, p. 162 Ibid, p. 2 Ibid, p. 2 Davies, Howard: The Financial Crisis and the Regulatory Response: An Interim Assessment, p. 2

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cannot be accused of more than this. International financial regulation should not be expected to protect financial markets from crisis. Still, the post-crisis financial regulation reforms will hopefully help in preventing future financial crises.

Work cited

The Financial Crisis: Who is to Blame? Howard Davies. Polity Press. 2010.

Global Financial Regulation: The Essential Guide. Howard Davies & David Green. Polity Press. 2008. Adaptation and Resilience in Global Financial Regulation. Douglas W. Arner. North Carolina Law Review, volume 89. The Financial Crisis and the Regulatory Response: An Interim Assessment. Howard Davies. Will be published in the International Journal of Disclosure and Governance. What is Systemic Risk, and Do Bank Regulators Contribute to It? George G. Kaufman & Kenneth E. Scott. The Independent Review, volume vii number 3, Winter 2003.
http://www.independent.org/pdf/tir/tir_07_3_scott.pdf