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
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
"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”
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”.
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.”
Longer Term Perspective
1900 -2008
Current Crisis
Source: Reinhart and Rogoff, 2008a
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 GateKeepers
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 New
Financial Architecture (NFA)
STRUCTURAL FLAWS IN THE
NFA POWERED THE BOOM,
CAUSED THE CRISIS AND
MUST BE FIXED
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), CDOssquared
• 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.
2.
3.
4.
Malaysia
India
Spain
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 reevaluation
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.
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 underestimation 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.
Motivations for Financial Innovation
Finnerty Studies
Study
Total Number of
Number
Percentage of
Security
motivated at
total
Innovations
least partly be
innovations
(1)
tax or regulatory
motivated by
reasons
tax or regulatory
(2)
reasons
(2)/(1) x 100
(%)
Finnerty, 1988
103
45
44
65
21
34
80
25
31
Finnerty, 1992
Finnerty and
Emery, 2002
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
work
3. 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 firewalls.
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 risktaking.
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.
V: End Too big and complex to Fail
Reform the Banking and Financial
System
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 Pay
2. Derivatives
3. Consumer Protection: Consumer Finance
Protection Agency
4. Investor Protection
5. Too big to Fail
6. 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