The Future of Financial Regulation is an edited collection of papers presented at a major conference at the University of Glasgow in spring 2009, co-sponsored by the Economic and Social Research Council World Economy and Finance Programme and the Australian Research Council Governance Research Network (GovNet). It draws together a variety of different perspectives on the international financial crisis which began in August 2007 and later turned into a more widespread economic crisis following the collapse of Lehman Brothers in the autumn of 2008. Spring 2009 was in many respects the nadir since valuations in financial markets had reached their low point and crisis management rather than regulatory reform was the main focus of attention. The conference and book were deliberately framed as an attempt to refocus attention from the former to the latter. The first part of the book focuses on the context of the crisis, discussing the general characteristics of financial crises and the specific influences that were at work this time round. The second part focuses more specifically on regulatory techniques and practices implicated in the crisis, noting in particular an over-reliance on the capacity of regulators and financial institutions to manage risk and on the capacity of markets to self-correct. The third part focuses on the role of governance and ethics in the crisis and in particular the need for a common ethical framework to underpin governance practices and to provide greater clarity in the design of accountability mechanisms. The final part focuses on the trajectory of regulatory reform, noting the considerable potential for change as a result of the role of the state in the rescue and recuperation of the financial system and stressing the need for fundamental reappraisal of business and regulatory models. The Future of Financial Regulation Edited by Iain G MacNeil and Justin O’Brien Oxford and Portland, Oregon 2010 Published in North America (US and Canada) by Hart Publishing c/o International Specialized Book Services 920 NE 58th Avenue, Suite 300 Portland, OR 97213-3786 USA Tel: +1-503-287-3093 or toll-free: +1-800-944-6190 Fax: +1-503-280-8832 Email: orders@isbs.com Website: www.isbs.com © The editors and contributors severally, 2010 The editors and contributors have asserted their right under the Copyright, Designs and Patents Act 1988, to be identified as the authors of this work. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, without the prior permission of Hart Publishing, or as expressly permitted by law or under the terms agreed with the appropriate reprographic rights organisation. Enquiries concerning reproduction which may not be covered by the above should be addressed to Hart Publishing at the address below. Hart Publishing, 16C Worcester Place, Oxford, OX1 2JW Telephone: +44 (0)1865 517530 Fax: +44 (0) 1865 510710 Email: mail@hartpub.co.uk Website: http://www.hartpub.co.uk British Library Cataloguing in Publication Data Data Available ISBN: 978-1-84113-910-4 Typeset by Forewords, Oxford Printed and bound in Great Britain by TJ International Ltd, Padstow, Cornwall CONTENTSCONTENTS CONTENTS Introduction: The Future of Financial Regulation 1 Iain MacNeil and Justin O’Brien Adam Smith’s Dinner 23 Charles Sampford US Mortgage Markets: A Tale of Self-correcting Markets, Parallel Lives and Other People’s Money 41 Robin Paul Malloy The Current Financial Crisis and the Economic Impact of Future Regulatory Reform 51 Ray Barrell, Ian Hurst and Simon Kirby Financial Engineering or Legal Engineering? Legal Work, Legal Integrity and the Banking Crisis 67 Doreen McBarnet The Future of Financial Regulation: The Role of the Courts 83 Jeffrey B Golden The Financial Crisis: Regulatory Failure or Systems Failure? 93 Paddy Ireland Beyond ‘Light Touch’ Regulation of British Banks after the Financial Crisis 103 Roman Tomasic What Next for Risk-based Financial Regulation? 123 Joanna Gray Risk Control Strategies: An Assessment in the Context of the Credit Crisis 141 Iain MacNeil Revisiting the Lender of Last Resort—The Role of the Bank of England 161 Andrew Campbell and Rosa Lastra The Global Credit Crisis and Regulatory Reform 179 George A Walker What Future for Disclosure as a Regulatory Technique? Lessons from Behavioural Decision Theory and the Global Financial Crisis 205 Emilios Avgouleas Credit Crisis Solutions: Risk Symmetric Criteria for the Reconstruction of Socially Fair Asset-backed Securities 227 Joseph Tanega ‘Corporate Governance’an Oxymoron? The Role of Corporate Governance in the Current Banking Crisis 253 Blanaid Clarke Board Composition and Female Non-executive Directors 271 Sally Wheeler Has the Financial Crisis Revealed the Concept of the ‘Responsible Owner’ to be a Myth? 287 Charlotte Villiers The Institutional Investor’s Role in ‘Responsible Ownership’ 301 Frank Curtiss, Ida Levine and James Browning Trust and Transparency: The Need for Early Warning 315 Howard Adelman Regulation, Ethics and Collective Investments 331 Pamela F Hanrahan Financial Crisis and Economist Pretensions: A Critical Theological Approach 341 Werner G Jeanrond Dealing Fairly with the Costs to the Poor of the Global Financial Crisis 351 Christian Barry and Matt Peterson Professions, Integrity and the Regulatory Relationship: Defending and Reconceptualising Principles-based Regulation and Associational Democracy 365 Ken McPhail Financial Services Providers, Reputation and the Virtuous Triangle 381 Seumas Miller vi Contents Toward A ‘Responsible’Future: Reframing and Reforming the Governance of Financial Markets 395 Melvin J Dubnick Re-regulating Wall Street: Substantive Change or the Politics of Symbolism Revisited? 423 Justin O’Brien The Banking Crisis: Regulation and Supervision 437 Kern Alexander Macro-prudential Regulation 445 Avinash Persaud The Regulatory Cycle: From Boom to Bust 455 Jeremy Cooper Contents vii INTRODUCTIONIAIN MACNEILAND JUSTIN O’BRIEN Introduction: The Future of Financial Regulation IAIN MACNEIL AND JUSTIN O’BRIEN * The global financial crisis is the latest, if most catastrophic, in a series of financial crises linked both with ‘boom–bust’ phases in the economic cycle and ‘regulate–deregulate’ swings in government policy. As the impact moves progressively and decisively from the financial into the real economy, the enormous political and socio-economic costs associated with a failure to address the question of the role of financial markets and insti- tutions more generally in society comes into clear view. The design of effective and flexible regulatory and corporate governance rules, principles and norms to address the inter- linked and intractable problems in both dimensions of the economy at national and international levels has become a global policy imperative. Moreover, the extent of state intervention required to stabilise financial markets has fundamentally transformed conceptual and practical dynamics. The power and influence of government within the regulatory matrix has been augmented considerably. The unresolved question is: what will it do with this power? Notwithstanding the certainty of the former chairman of the Federal Reserve, Alan Greenspan, that it is impossible to have a perfect model of risk or that it is difficult to legislate for ethics, it has become essential that basic flaws in risk-based regulatory techniques be remedied and that the integrity deficit in regulatory frameworks be addressed. 1 The G-20 Summit in London in April 2009 laid the foundations for a new international regulatory architecture covering all systemically important financial institutions and markets (including, significantly, hedge funds which, through judicious structuring, have been effectively unregulated to date) as well as systemically important financial instru- ments (such as securitisation and credit derivatives). The EU has proposed the establishment of a European Systemic Risk Council and a European System of Financial Supervisors. Much work needs to be done to put flesh on this skeletal framework, not least how the superstructure will integrate or subsume national regulatory priorities, particu- larly over the governance of the City of London. The US has also begun the process of overhauling its dysfunctional regulatory system, a process that it likely to generate turf 1 A Greenspan, ‘We Will Never Have a Perfect Model of Risk’, Financial Times, 17 March 2008, 13; A Greenspan, ‘Capitalizing Reputation’, speech delivered at Financial Markets Conference, Federal Reserve Board of Georgia, 16 April 2004. * Alexander Stone Professor of Commercial Law, University of Glasgow and Professor of Law, University of New South Wales, Sydney. wars in Washington for some time to come. Changes in regulatory structure alone, however, are unlikely to be the answer. Moreover, a retreat to legal rules will not necessarily guarantee better ethical practice or inculcate higher standards of probity. Indeed, the passage of legal rules may itself constitute a serious problem: it creates the illusion of change. Thus, for example, it appears that the risk management procedures required by the Sarbanes-Oxley Act (2002) had the unfortunate consequence of discounting the benefits of critical thinking within financial institutions and their advisers as to the risks associated with the expansion of securitisation. While substantial progress can be achieved through better rules, it is clear that the entire regulatory framework must be underpinned by much clearer concepts of accountability and integrity applicable to individuals, entities and markets as a whole. Addressing the accountability and integrity deficit requires an expansion of focus beyond legal restraints, irrespective of whether they are formulated as generalised principles or more detailed rules. It is only through such an approach that the inevitable gaps in any regulatory framework can be resolved adequately. Latest estimates by the International Monetary Fund put the total cost of the multi- faceted collapse at $4 trillion, the vast majority of which can be attributed to systemic failures of corporate, regulatory and political oversight in the US. Many of its leading bankers have been forced to resign, castigated for destroying their institutions through a combination of hubris, greed and technical gaming (ie compliance with but derogation from the underlying principles of regulatory rules). The crisis, however, was not just a failure of rules-based regulation. In the UK, the Financial Services Authority (FSA) has seen its vaunted principles-based approach to regulation fall into as much reputational disrepute as that country’s leading banks, whose forced nationalisation has added to the humiliation of the City of London. Similar dynamics are apparent in countries as culturally, politically and economically divergent as Iceland and Ireland. Each has seen its banking system fail, with profoundly destabilising effects on the underlying economy. Ostensibly more cautious regulatory frameworks within the EU have proved equally deficient. The ‘passport system’, allowing banks to operate across borders with supervision vested in the home jurisdiction, was a demonstrable failure, as witnessed by the collapse of regional German banks operating in Dublin and of Icelandic banks ‘passporting’ into the UK. Regulatory arbitrage over the implementation of directives relating to the finance sector reinforced the problems. Much more fundamentally, however, it is important to stress that, although there has been criminal activity in the margins, the global financial crisis is the result of ‘perfectly legal’ if ethically questionable strategies. After taking into account specific national factors, three interlinked global phenomena are at play: flawed governance mechanisms, including remuneration incentives skewed in favour of short-term profit-taking and leverage; flawed models of financing, including, in particular, the dominant originate-and-distribute model of securitisation, which promoted a moral hazard culture; and regulatory structures predicated on risk reduction, which created incentives for risk capital arbitrage and paid insufficient attention to credit risk. Each combined to create an architectural blueprint for economic growth in which innovation trumped security. Financial engineering, in turn, created complex mechanisms that, ultimately, lacked structural and ethical integrity. Take, for example, the collateralised debt obligation and credit default swap market, which generated enormous fee income for the investment bank that created or distributed the instruments. This raises real doubts as to whether the investment bank in question acted in an ethical manner, even where there has been formal compliance with legal obligation. Those doubts have also been raised in 2 Introduction [...]... For MacNeil, Capacity is a function of the institutional and normative structure of a system of regulation and of the underlying legal system on which it is superimposed It is also a function of the mix of risk control strategies that are adopted within the system, since each strategy offers a distinctive approach to the process of regulation For MacNeil, the foundational assumptions of risk-based regulation. .. trace the wide macro-level impacts of the initial shock In their examination of how the securitisation crisis crossed the Atlantic with such ferocity, Barrell, Hurst and Kirby place the blame on the combination of ‘light-touch regulation for failing to prevent the crisis and excessive fear of counter-party risk in its immediate aftermath for exacerbating it The result has been the most severe financial. .. application of legal rules as well as other regulatory techniques that have emerged from the study of corporations and professionals He concludes that the much touted claims of the superiority of the UK’s light touch and principles based system of market regulation has been shown to be hollow as, at the end of the day, this has merely amounted to a lack of regulation The reputational costs to the FSA,... storm’ or financial tsunami’; the conflation of factors beyond control Similar defences, it will be recalled, were used during the conflicts of interest investigations that accompanied the collapse of Enron, WorldCom and Tyco in the accounting scandals at the turn of the century The falsification of the efficient market hypothesis and the belated acceptance that the pursuit of (deluded) self-interest... the corporate form itself is inimical to virtue There is prescience to Alasdair MacIntyre’s argument that the ‘elevation of the values of the market to a central social place’ risks creating the circumstances in which the concept of the virtues might suffer at first I Kant, Grounding for the Metaphysics of Morals (1785) 30 Indeed, in the US it is illegal under s 404 of the Sarbanes-Oxley Act In other... and other complex instruments is particularly associated with London, there is some perception in the UK of an ‘anti-London’ agenda To the extent that the ‘light-touch’ regulatory regime favoured by the UK has been viewed in some parts of the EU as one of the main causes of the crisis, that perception is probably correct; however, it remains to be seen how the dynamics of EU politics as well as the. .. evidenced in the debates over the accountability of central banks and regulators and the turf wars that are now being fought on both sides of the Atlantic over the survival, shape and remit of regulatory authorities At the same time, it is essential to emphasise that overarching these micro-failures is an ideational meta-failure of the terms of reference that underpinned the trajectory of corporate... ultimately a lender of last resort The Act also formalised the Bank’s role in ensuring financial stability, although a lack of powers associated with that role has led the Governor to complain that the Bank can do no more than ‘issue sermons or organise burials’.38 From there the focus shifted to the process of recapitalisation of the major banks and the emergence of the government as the major or majority... other reform proposals are viewed with much less enthusiasm in the UK than in continental Europe One is the European Commission proposal for greater regulation of hedge funds;45 the other is the European Parliament proposal to mandate that some segments of the ‘over -the- counter’ (OTC) market in derivatives and other complex financial instruments be traded on regulated markets.46 Since the growth of. .. and financial regulation reform in the decades either side of the turn of the millennium A particularly striking feature of corporate and regulatory responses to the financial crisis has been the paucity of institutional memory At both Congressional hearings in Washington and testimony provided to the Treasury Select Committee in Westminster, banking executives claimed that the crisis was the result of . an ideational meta-failure of the terms of reference that underpinned the trajectory of corporate governance and financial regulation reform in the decades either side of the turn of the millennium. A. Canada) by Hart Publishing c/o International Specialized Book Services 920 NE 58th Avenue, Suite 300 Portland, OR 9721 3-3 786 USA Tel: + 1-5 0 3-2 8 7-3 093 or toll-free: + 1-8 0 0-9 4 4-6 190 Fax: + 1-5 0 3-2 8 0-8 832 Email:. mechanisms. The final part focuses on the trajectory of regulatory reform, noting the considerable potential for change as a result of the role of the state in the rescue and recuperation of the financial