recent trends and problems of the global financial regulations

8/9/2019 Recent Trends and Problems of the Global Financial Regulations

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FINANCIAL LAW ANDFINANCIAL LAW ANDREGULATIONSREGULATIONS

WEEK 2

Recent Trends and Problems of the

Global Financial Regulations


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Further to last week, we are going to look

into: Specific problems with financial assets

Regulations in response to bank failures inrecent decades

Types of regulatory framework


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George Soros (finance guru): financial markets arealways biased ?

Distorted views of market participants can affect thefundamentals of market ?

Equilibrium the ability of markets to find their own price

levels cannot be taken for granted

Regulation is based on the outdated concept that marketscan regulate themselves ?

Do we really understand how does

the Financial Market works?


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Financial Markets

Traditionally greater emphasis was placed on themarket forreal assets such as factories, land andother means of production

The role of financial markets was seen tosupport the market for real assets which wouldalways find their own equilibrium

Therefore, developments in financial marketsshould only be a reflection of what washappening in the market for real assets


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REAL ASSETS-house, factories,

- land, etc

FINANCIAL ASSETS- stocks, bonds, etc

Financial Market


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Financial Markets

But the health of financial markets determines confidence which drivesconsumption, savings and investment economic development

Contemporary financial markets can be very profitable for majorintermediaries

Greater risk taking may significantly increase profits but can alsocause financial failure

Failure can lead to a market crisis and a loss of liquidity that canquickly spread though out the world


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Effectiveness of regulations

Much regulation has developed in response to aseries of market failures.

Regulation does not cover all areas of risk suchas derivatives

Regulation is often based on the belief thatmarkets know best hands off


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Theories of Regulation (contd)

The Theory of a Market for Regulations Wealthy people want regulations to support their

own private interests

Regulators are sympathetic to the regulated The Dynamic Theory Dynamic interaction between consumers,

regulators, and the regulated, until a equilibrium

between consumers and the regulated firmsRegulatory Dialectic Constant evolutions


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Theories of Regulation

The Theory of the Public interest Inefficient market practices may result from

monopolies, and other external conditions

Government should create regulations to protectpublic interests

The Capture Theory Government regulations are not necessarily in the

public interest Only bankers know how to regulate a bank? The regulated end up regulating themselve.


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Looking back

1929 US Wall Steet Crash. Between 1929 and1931 employment reduces by a third

US Congress passes the Securities Act in 1933requiring registration of interstate offers for sale ofsecurities

US Congress passes the Securities Exchange Act in

1934 to govern secondary trading of securities

Regulation curbed abuses which led to the crash


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Bank failure in Europe

In 1931 the Credit Anstalt Bank in Austria failedMuch of Europe including Germany and Englandwas badly affected

The Bank of England organised a rescuepackage

But the concept of international regulation is far

from being established


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More bank failures in 1970s

Differences in economic performance force the end offixed (pegged) rates in 1971 and major currencies areallowed to float (market determines rates)

In 1974 three banks fail due to poor management andlarge currency losses:

Herrstatt Bankhaus in Germany British Israeli Bank in London, and

one of its creditors: Franklin National Bank - USA


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Criminal intent

The Franklin National Bank (Franklin Bank) was previouslybought by Michele Sindona (the Shark)

Close ties to the Mafia (Gambino family) and Banco

Ambrosiano and its main shareholder (Vatican Bank)

He used the Franklin Bank to expand his criminal activities inthe USA drug trafficking money laundering

He apparently had ties to the US Republican Party and theNixon administration


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Criminal intent

Sindona was later extradited to Italy where he wassentenced to serve time in prison

In prison he later he died of Cyanide poisoning whilst

drinking a cup of coffee (murdered ?)

In 1982 Roberto Calvi (chairman Banco Ambrosiano)was found dead hanging from Blackfriars Bridge inLondon with a stone in his mouth

The Franklin Banks assets were acquired first byEuropean American Group and later by Citibank


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Early 1970s characterised by serious disruptions incurrency and banking bank failures

G10 Central Bank governors establish the Basel

Committee on Supervision

Herrstatt (a German bank) failure showed that regulatorresponsibility was not clear and threatened USsettlement system

Which supervisor (in what country) if any wasresponsible for the foreign operations of a bank ?

Responsive regulations


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Latin America financial crisis During the 1970s countries such a Brazil, Argentina

and Mexico borrowed heavily from major foreignbanks to finance industrialization

International banks made good profits

Between 1975 and 1983 external debt increasedfrom US$ 75 B to US$ 315 B much short term.

Annual interest and principal repayments increasedfrom US$ 12 B to US$ 66 B


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Latin America financial crisis

Oil crisis (prices quadrupled) caused recession during1970s and 1980s and borrowers faced liquidity problems

But US$ deposits made by oil exporting countries were later lentto Latin American borrowers (governments). Money wasrecycled!

1982 Mexican Finance Minister announced that Mexico

could not meet repayment schedule.


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Latin America financial crisis

Lenders lost confidence and refused to extend furthercredit loans were called in

But too late capital flight out of the region

Major banks such as Chase Manhattan and Citibankwere badly exposed could have failed

IMF provided emergency loans and assistance up tothe end ofthe 1980s. Loans were used to repay banks.


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Responding regulations

Focus during the 1980s was on capital adequacy 8%

1988 Base lI but regulators could not commit theirnational parliaments to agree and enact intodomestic / national law

Parties could only commit to do their best


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Basel II

Why were lending mistakes still being made ? Basel accord needed to berevisited

In 1996 the updated Basel II clarified the primary responsibility of homecountry supervision rather than host country

EU countries enact into domestic law to provide locally headquarteredbanks with an EU passport

EU requires incorporation into domestic law but not the USA, Canada andJapan


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Lesson: Moral hazard

Why did the banks lend so much money when itshould have been reasonably clear that the borrowerswould default ?

Were the banks learning to take on excessive risk thatcould eventually be passed on to the tax payers ?


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More troubles with thefinancial markets

1980s, 1990s and

2000s


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Financial engineering 1980s

Availability of cheap computing power powered thegrowth of international currency trading throughinternational banking system

Markets forderivatives grew but these remained largelyunregulated

But derivatives can be used to both minimise and to

create risk

*Intl Swap and Derivatives Association


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Failure of BICC in 1990s

1991 Bank of International Credit andCommerce (BICC) fails due to criminal activitiesof its founders and senior management

Depositors worldwide including Hong Kong losetheir savings

Bank headquartered in London but owned by aholding company in Luxemburg


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Failure of BICC in 1990s

Liquidator sued Bank of England for negligence lack of supervision

Bank of England claimed that Luxemburg wasresponsible as the ultimate parent wasdomiciled there

Bank of England claimed that a heavy handedapproach would damage the London financialmarkets


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Mexican crisis in 1994

1994 Mexican financial crisis triggered by the sharpdevaluation of the Mexican Peso

Heavy government borrowing using Tesobonos (denominatedin Pesos but indexed to the US$ using a currency peg)

Political instability, poor banking systems, bad lending,corruption

Central Bank depleted US$ reserves forced to let Peso float


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Mexican crisis in 1994

Refinancing (rolling over debt) becameimpossible

Capital flight puts further pressure on Peso

US under President Clinton along with IMF, BIS

and others organised a US$ 50 B bail out


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Asian financial crisis in 1997

Asian financial crisis in 1997 was fuelled by banks inmostly Thailand and Indonesia borrowing US$ at lowinterest rates and re-lending in local currency at highrates.

Lending created speculative bubble and opportunities forcorruption

Borrowers defaulted and banks became insolvent The Thai Baht collapsed and the currency peg to the US$ was

severed

The IMF provided a US$ 40 B support programme


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Russian financial crisis in 1998

In response to the Asian crisis global demand andprices for commodities such as oil and metal ores fell

Compounded by declining productivity, an overvaluedexchange rate and a chronic fiscal deficit

In 1998 Russia announced that it could not meet its

obligations on its sovereign bonds - default


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Russian financial crisis in 1998

IMF and World Bank provided a US$ 26 B aidpackage

Investors worldwide started to repatriate shortterm investments from developing countriesworldwide

Classic example of the Domino effect - Asian

and Russian crises in turn affect Latin America


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New developments privateequity and funds

New forms of investment vehicles become popular in the1990s:

Private equity using mostly pension funds to make short term

leveraged investments in private companies. Banks supplylending. Typically unregulated

Hedge funds which use funds (private and bank loans) tomake even shorter term speculative investments in foreign

currencies and shares. Typically unregulated

Securitisation typically selling corporate bonds tofinance home loans


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Another collapse

The Long Term Capital Management group (LTCM) hedgefund collapsed towards the end of 1990s. Foundersrepresented the elite of financial minds in the US

They claimed to have developed a zero risk model ?

But they lost US$ 1.25 B of investors money on a wrong bet arbitrage (after the Russian economic crisis)

The New York Federal Reserve Bank organised a rescuethrough a group of investment banks who were its primarycreditors


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Deregulation..

In 1999 the US Congress passed the Gramm Leach Bliley Act

Allowed banks to offer a variety of savings,investments and insurance products under one roof For example, Citibank merged with Travelers Group

Reversed 1930s legislation which had separated

commercial and investment banking

Swept away regulatory safeguards and oversights


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Enrons failure in 2001

In 2001 the Enron corporation failed

Fortune magazine had named it the most

innovative company for six consecutive years

Credit rating agencies had rated it highly

Heavy debt and overstated profits wereconcealed by carefully planned accounting fraud


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Enrons failure in 2001

Arthur Andersen (companys auditors) were forcedto cease business when it was alleged that theywere partly responsible and when their employeeswere discovered to be destroying evidence

CFO later cooperated with the investigators

US Congress passed the Sarbanes Oxley Act in

2002 to address shortcomings revealed in thescandal

Credit rating agencies claimed they were misled


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Argentinean debt crisis in2001 Crisis in 2001 caused by several factors:

High unemployment

Weakened economy

Overvalued exchange rate

Caused run on banks deposit withdrawals restricted

Could international regulation have helped ?


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The Internet Boom

1999 - Merrill Lynch operated an Internetgroupwithin its investment banking division

Analysts were required / pressured to writepositive reports on companies going public Buy recommendations

At the same time they were sending emails toeach other describing shares in those samecompanies as a piece of crap


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The Internet Boom

New York Attorney General Eliot Spitzer filed an affidavitwith the court

2002 Merrill Lynch declined to go to trial and instead paid asum of US$100 M without any mission of guilt to end theinvestigation.

2003 SEC and New York Attorney General and others agreedout of court settlement of US$ 1.4 B with 10 financial firms

Included US$ 80 M paid by Lehman Brothers


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Financial Tsunami


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New fast money-making idea withthe mortgage financing business

During early 2000s, originators made money throughcommissions earned from creating the mortgages butpassed the liability itself on to others

Mortgage originators had securitised the loans and sold themthroughout the world

Banks throughout the world bought these bonds and lost

significant amounts of money bad luck ?


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A series of failures in the U.S.banking sector in 2008

Bear Stearns failed acquired by JP Morgan Chase Employees were partly paid in company shares which

became worthless

Merrill Lynch failed taken over by Bank of America Lehman Brothers failed partly acquired by

Nomura


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Toxic assets

Sub-prime mortgage started to unfold in 2007

US banks had lent trillions of dollars to finance US

home purchases

But borrowers could not repay and defaulted

As property prices fell, lenders could not recover loanvalues


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Mini bonds in Asia Credit linked derivatives direct default risk to the investor

Apparently guaranteed by Lehmann Brothers but thebank failed

Name misleading ? Claims of misrepresentation ?

Investor protection - sold to unsophisticated retailinvestors why ?


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Second Tsunami ?

Similar amounts of mortgages were sold with aprovision to maintain low interest rates for the firstthree years

They are now starting to reset to higher (normal)rates

Defaults are expected to increase significantly second wave of toxic assets over the coming two tothree years

recent trends and problems of the global financial regulations

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