Inquiries and Proposals for Reform
In the aftermath of the global financial crisis, a number of regulatory authorities and government agencies proposed wide-ranging reforms to the regulatory frameworks of the world’s financial markets. These bodies undertook and proposed extensive reforms to the way financial markets would be regulated, including proposing reforms aimed at improving international coordination.
Reform proposals that were put forward included enhanced regulation of deposit banks, investment banks, non-bank financial institutions, brokers and financial intermediaries. Some commentators had argued that the crisis revealed much deeper structural weaknesses and vulnerabilities with the entire system of market capitalism. There had also been widespread criticism from investors, businesses and the unemployed over the handling of the crisis, particularly with the large-scale bailouts that had been proposed and implemented for Wall Street investment firms. Many had expressed concern that bailouts would contribute to a moral hazard, where the firms that had contributed to the crisis would be favoured with generous taxpayer-funded assistance, by contrast with the treatment of the unemployed.
The ideologies of Karl Marx and modern-day socialist revisionists found much favour in the concerns of the unemployed during the height of the crisis. One unforgettable consequence of the recent financial crisis was the spillover of financial mayhem from financial markets into the wider community when the Great Recession emerged to devastate both developed and emerging economies. Millions of workers would lose their jobs, factories and business would be forced to close, and the long-term unemployed would become the norm in previously booming industrial economies.
Governments and policymakers around the world sought to overcome the worst of the crisis and to avoid a repeat of a global depression by putting forward proposals for regulatory reform. Many of the suggested reforms called for international coordination, expressing the realization that without a global solution to a global problem any suggested reforms would be largely ineffective. Other proposals relied on domestic intervention aimed at strengthening national regulatory frameworks. It was now clear that the status quo in terms of regulation could no longer be maintained, and the world’s banking and financial systems would be required to undergo considerable change to make them more robust and less susceptible to global imbalances.
The Group of Thirty (G30), a private think tank made up of 30 participating members, undertook an investigation of the causes of the global financial crisis. The G30 members focused their attention specifically on how the financial system might be organized once the current crisis has passed. In January 2009, the G30 released its report on the causes of the current crisis and the impact the crisis has had on the international financial system.1
The G30 Report on the GFC attempted to address the following issues: policy issues related to redefining the scope and the boundaries of prudential regulation; reforming the structure of prudential regulation, including the role of central banks, the workings of the “lender of last resort,” the provision of a “safety net,” the need for greater international coordination, improving governance, risk management, regulatory policies, accounting practices and standards, and improvements in transparency and financial infrastructure arrangements.2
In addressing the above policy and related issues, the G30 made a number of recommendations designed to overcome perceived weaknesses in the global financial system. These suggestions included making improvements in supervisory and prudential regulation of financial markets. One of the key recommendations to emerge from the G30 report was the need to enhance and improve prudential regulation and supervision of global banking institutions. According to the G30, a single regulator should have the responsibility to prudentially regulate all banks and government-insured deposit-taking institutions. A single regulator would achieve more efficient regulation of banking institutions with the largest and most complex institutions subject to greater scrutiny and supervision.3
By targeting the largest banking institutions, the G30 recognizes not only the economic importance of banks and lending institutions but also the increased likelihood of systemic problems flowing from a big bank collapse. The G30 further recommended placing nationwide limits on deposit concentration for banks and other government-insured deposit-taking institutions. Avoiding excessive concentration in national banking systems would reduce systemic risk and improve overall systemic stability because there would be greater diversification of bank activity. With reduced concentration among banks as well as other financial institutions, risk would be diversified within the global banking system. Through diversification the likelihood of systemic risk or contagion would be reduced as default risk is spread more broadly through the financial system.
Enhanced prudential regulation of financial institutions was not to be limited to banks. In its report the G30 further recommended that consolidation should occur with the supervisory practices of prudential regulators over non-bank financial institutions.4 The regulation of non-bank financial institutions recognized the growing importance of investment banks, broker–dealers and other financial intermediaries which were active in global financial markets.
Money market mutual funds and private equity providers should also be made subject to prudential regulation. Scrutiny of private fund managers should extend to periodic regulatory reporting as well as public disclosure of material information: “the size, investment style, borrowing, and performance of the funds under management.”5 According to the G30, a prudential regulator should also have the authority and mandate to “establish appropriate standards for capital, liquidity, and risk management.”6
Another key recommendation made by the G30 was the need to develop and further enhance international regulatory and supervisory coordination.7 The GFC has been a truly international crisis, which has exposed the weaknesses in the global financial architecture. The G30 recommendation to improve international coordination is consistent with focusing regulatory and prudential attention on cross-border transactions and offshore banking institutions, and monitoring global systemic risk. Minimizing gaps and overcoming weaknesses in international regulation by enforcing international standards represents a pragmatic approach to dealing with any future global crisis.
Recognizing the importance of increasing collaboration and supervisory oversight of international banking organizations,8 the G30 concludes that through greater collaboration with international agencies and information exchanges, leverage and liquidity mismatches could be minimized.9 The G30 further recommends that institutional policies and standards be enhanced and strengthened, especially in the areas of corporate governance and risk management,10 regulatory capital standards,11 and liquidity risk management.12
To minimize the potential for any future financial crisis, the G30 made a number of important recommendations regarding the regulation of financial markets and financial products.13 Importantly, the G30 recognizes the challenges posed by off-balance sheet financial arrangements which can have a material effect on a firm’s risk profile and vulnerability. With off-balance sheet liabilities, a firm’s overall indebtedness can be understated. One major consequence of understating an entity’s leverage position is that the entity’s risk profile can be adversely affected. A firm can appear to be in a strong financial position but in reality can be exposed to high levels of debt. The G30 proposed that all forms of off-balance sheet financing should be disclosed to investors and lenders, which, in turn, would improve the overall level of transparency.
Similarly, the G30 were of the view that the regulation of rating agencies should also be reformed to achieve improved transparency, particularly at the international level.14 Improving international collaboration between rating agencies would enhance the investor’s ability to monitor, evaluate and review a firm’s overall risk profile.15
In a related theme, the G30 were also cognisant of the need to improve the regulation and supervisory oversight of Over-the-Counter (OTC) derivatives markets.16 OTC markets have traditionally been the domains of sophisticated investors, as opposed to retail investors. Hence, OTC markets have been exposed to lower levels of regulation and supervisory oversight. The regulatory position of OTC markets is to be contrasted with exchange-traded markets, which typically have a higher level of regulatory and supervisory oversight. This is because exchange-traded markets have more involvement from retail end-users. Consumer-type protections are more relevant for exchange-traded derivatives markets. Market regulators have also vigorously enforced disclosure rules for retail end-users of exchange-traded derivatives products.
Since OTC derivatives markets have been subject to lower regulatory burden, product issuers of financial derivatives products have incentives to engage in regulatory arbitrage. The regulatory game- playing behaviour was not limited to the differences that existed between the regulatory burdens for futures markets and OTC markets.17 There was some evidence to suggest that product issuers may have also been attempting to circumvent rigid securities laws when developing new OTC financial products.18
Securities market regulators such as the United States Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC) had adopted aggressive enforcement practices when policing issuers of OTC financial products. Hence, it was not uncommon for financial market regulators in the form of the SEC and CFTC to prosecute product issuers of OTC financial products with alleged breaches of securities laws or futures market regulation. Indeed, the practice was not limited to financial market regulators in the United States.
Since the GFC there have been a number of proposals put forward for further reform of financial derivatives markets regulation. Much of the regulatory focus has fallen on OTC derivatives markets. One such proposal, which has attracted the attention of US regulators as well as market participants, has involved proposing to transfer OTC derivatives activity to an exchange-based system of settlement and clearing. Financial market regulators in the United States proposed that OTC derivatives markets in the form of swaps, forwards and other OTC derivatives should be centrally cleared by certified and regulated derivatives clearing organizations (DCOs).19
The basic premise for proposing centralized clearing of OTC derivatives is that OTC derivatives markets lacked transparency. With financial market regulators not knowing what was being bilaterally negotiated and settled between OTC counterparties, it was argued that OTC market practices could contribute to increased systemic risk and contribute to financial instability. Hence, it was proposed that one way of improving transparency and reducing the potential for systemic or contagion risk for financial markets was to have a centralized and regulated clearing system for OTC derivatives markets.
As is discussed in Chapter 2, debates concerning the regulation of financial derivatives have not been without controversy. OTC derivatives were often complex instruments which had not been well understood by all. Market regulators, including the SEC and CFTC, had been calling for wholesale changes to the regulatory landscape for years. Greenspan was of the view that derivatives by themselves posed little actual risk; however there was insufficient understanding of how OTC derivatives could contribute to systemic risk:
Yet beneath all of the evidence of the value of derivatives to a market economy, there remains a deep-seated fear that while individual risks seem clearly to have been reduced through derivative facilitated diversification, systemic risk has become enlarged, as a consequence. Without question, derivatives facilitate the implementation of leveraged trading strategies, though the very technology that has made derivatives feasible has also improved the ability to leverage without derivatives. Nonetheless, the possibility of increased systemic risk does appear to be an issue that requires fuller understanding.20
Derivatives markets had been considered to be at least a contributory factor to the current crisis, a point that was reinforced by the Financial Crisis Inquiry Commission, which concluded that OTC derivatives “contributed significantly to the crisis.”21 The Financial Crisis Inquiry Commission formed the view that OTC derivatives and, in particular, credit default swaps were at the centre of the financial storm that engulfed the entire financial landscape when the US housing bubble burst.22
United States Financial Crisis Inquiry Report
The Financial Crisis Inquiry Commission in the United States was established soon after the emergence of the global crisis. Charged with providing a detailed examination of the causes of the financial crisis, the Inquiry conducted a number of hearings with witnesses that were at centre stage of the financial meltdown.23 The Commission’s legal authority to conduct the enquiry was given legislative backing in the form of the Fraud Enforcement and Recovery Act 2009.24 The Commission concluded its enquiry into the causes of the global financial crisis in January 2011.
After obtaining all of the submissions and evidence from the witnesses, the Financial Crisis Commission arrived at nine conclusions regarding the causes of the current global financial crisis. The overall finding from the Commission was that the current crisis was avoidable. According to the Commission there had been systemic failure in the supervision and regulation of financial markets and financial products.25 The Commission was also of the view that the US government and regulatory authorities were under-prepared for the crisis and there had been a widespread failure in professional ethics and standards regarding financial markets, including financial intermediaries.26
Armed with the findings from the public hearings and the conclusions from the majority of the members of the Commission, the Financial Inquiry Commission’s Final Report also began laying the groundwork for reform. The Commission was critical of what it considered to be an outdated and outmoded system of regulation and supervisory oversight of US financial markets.27 The Commission was also critical of the role ratings agency played in the financial crisis and the fact that credit-rating agencies had been largely unregulated by the SEC as well as other market regulators.28
The parallel banking system and its participants also came under criticism for allowing shadow financial institutions to operate largely unchecked within the United States.29 According to the Commission, the shadow banking system had contributed significantly to the global financial crisis because of the large build-up of risk. The unregulated nature of the shadow banking sector meant that market regulators were either not aware of, or failed to fully appreciate, the level of risk that was posed by the parallel system to conventional banks and financial markets.30
The Commission also noted that banking and market regulators had not properly regulated traditional banks and investment banks. The inadequacies of the regulatory and supervisory framework led to structural weaknesses and flaws in lending and risk management practices. This, in turn, contributed to a further build-up of risk at the time when the US housing bubble had begun to unwind. The widespread use of credit default swaps and CDOs further led to a build-up of risk because the derivatives were complex instruments, opaque and not properly understood by investors.
The conclusions from the Commission were consistent with the premise that the regulatory and supervisory oversight framework of US financial markets had failed to achieve its stated aims. The Commission was of the view that further reforms of financial markets regulation would be required to improve market integrity and promote overall financial stability. Enhanced regulation and supervisor oversight would provide improved monitoring of bank and investment bank trading activities. Providing greater legislative powers and authority to the SEC, the CFTC and the US Federal Reserve would also allow for an improved legal mandate for the monitoring and supervision of trading activity within US financial markets.31
Regulation would also extend to covering perceived weaknesses and gaps in the current regulatory and supervisory framework. OTC derivatives such as credit default swaps, synthetic derivatives, structured products and collateralized debt obligations would all now be regulated by the SEC or the CFTC.32 OTC derivatives markets would be regulated in a similar way to the way securities and futures contracts are currently regulated under the Securities Exchange Act 1934 and the Commodity and Futures Trading Act 1974.
US Senate Report: Wall Street and the Financial Crisis
In April 2011, the US Senate Permanent Subcommittee investigating the origins of the 2008 financial crisis released its report.33 In conducting its investigation the Permanent Subcommittee issued numerous subpoenas, conducted over 150 interviews and consulted with government departments, and academic and private sector experts.34 The Subcommittee also reviewed and analysed millions of pages of transcripts and documents held by the SEC, as well as other regulatory and banking authorities.35
The US Senate Subcommittee found that a number of failures existed which had contributed to the GFC. These failings included regulatory failures on the part of the Office of Thrift Supervision, the issuing of inflated ratings by rating agencies Moody’s and Standard & Poor’s, and investment bank abuses involving Goldman Sachs and Deutsche Bank.
The findings from the US Subcommittee prompted the Subcommittee to make a number of recommendations for reforms to the Office of Thrift Supervision, investment banks, high-risk lending practices and credit-rating agencies. In relation to high-risk lending, the Subcommittee recommended that the practice should be curtailed and all mortgages which are deemed to be “qualified residential mortgages” have a low risk of delinquency or default.36
The Subcommittee was critical of the role of credit-rating agencies in issuing credit ratings “for tens of thousands of US residential mortgage-backed securities (RMBSs) and collateralized debt obligations (CDOs).”37 By issuing the AAA highest rating for a large proportion of residential mortgages and structured financial products, the credit-rating agencies effectively deemed the securities “safe investments.”38 The Subcommittee found that the issuing of AAA and other investment-grade ratings for the mortgage securities and other related financial instruments was inaccurate and “introduced risk into the US financial system and constituted a key cause of the financial crisis.”39
The Subcommittee revealed that typically, AAA-rated investments have less than 1% probability of default. This is because AAA credit rating provides investors with reassurance that the investment is safe and prudent. However, by 2010 the Subcommittee found that over 90% of the AAA credit ratings that were given to sub-prime mortgage-backed securities and CDOs had been downgraded to junk status.40
The downgrading of the mortgage-backed securities and CDOs led to significant losses for investors. The losses were shared broadly among the financial community to include large-scale investment houses, investors both large and small, pension funds, trustees, local authorities, government authorities and private investors. The losses flowing from sub-prime mortgages and CDOs undermined investor confidence and increased instability and volatility in financial markets generally.
The Subcommittee reported that its investigations discovered a number of factors that were responsible for the inaccurate credit ratings that were issued on sub-prime mortgage debt and structured financial instruments. According to the Subcommittee, the factors included conflicts of interest, inaccurate credit-rating models, inadequate surveillance and rating resources, market share gains and pressure from investment banks.41
Product issuers that required a credit rating for the products they intended to market and sell to the public provided remuneration to the ratings agencies.42 According to the Subcommittee’s investigation, since rating agencies were required to rate an issuer’s financial product, the issuer would often “shop around” for the highest obtainable rating. This process was called “ratings shopping” and the practice had been reported to the SEC as early as 2003: “the potential conflicts of interest faced by credit rating agencies have increased in recent years, particularly given the expansion of large credit rating agencies into ancillary advisory and other businesses, and the continued rise in importance of rating agencies in the US securities markets.”43
The perceived conflict of interest between credit-rating agencies and issuers of financial products was of particular concern to the Subcommittee. In its recommendations for reform, the Subcommittee proposed that regulation be introduced to authorize the SEC to enhance its powers and authority for inspection, examination and regulatory authority so as to ensure that credit-rating agencies incorporate effective internal control procedures.44 The internal control procedures would also extend to covering credit-rating methodologies and employee conflicts-of-interest safeguards designed to improve the overall accuracy of ratings.45
The Subcommittee also recommended further reforms to the regulation of credit-rating agencies, including providing the SEC with further regulatory authority to rank rating agencies in terms of their overall performance and to make the ranking available to investors and the public.46 Accountability of credit-rating agencies was also high on the agenda of the Subcommittee.47 According to the Subcommittee, the SEC should assist investors in filing civil law suits for any inflated credit ratings that are issued by credit-rating agencies, where the agency “knowingly or recklessly fails to conduct a reasonable investigation of the rated security.”48
At one level the accountability measures proposed by the Subcommittee in relation to inaccurate credit ratings may be seen as a muted response, since no new laws are proposed by the Subcommittee. However, on another level the Subcommittee was also foreshadowing a strong signal that market regulators, including the SEC, would take seriously inaccurate credit ratings issued by a credit-rating agency if the agency knowingly or recklessly failed to conduct a proper investigation into the rated security. In other words, if circumstances exist to demonstrate that a credit-rating agency knowingly or recklessly issued an inaccurate credit rating, the SEC could take action against the agency.
The Subcommittee’s recommendation was squarely aimed at improving accountability of credit-rating agencies, particularly when investors have relied upon a possibly inaccurate credit rating to make their investment choices. The Subcommittee was also of the view that the US federal government’s reliance on private credit ratings should also be reduced.49 Although the Subcommittee has made this recommendation, it is unclear what federal government authorities would use in their place when evaluating alternative investments. After all, credit ratings do serve a useful purpose in providing information concerning the risk profile and risk assessment of alternative financial investments. Moreover, the recommendation does not extend to state governmental agencies or local authorities, which often have mandated requirements to invest surplus funds or pension funds into AAA-rated financial products.
Many institutions and investors, both public and private, rely on credit ratings to assess the creditworthiness and risk profile of financial products that are issued and sold into the market.50 The requirement to only consider AAA-rated financial instruments by these state and local authorities is usually enshrined in law or in constitutions. The same investment rules generally apply to private trustees, superannuation, and pension funds which have governing documents in the form of constitutions that lay down requirements for the trustee to invest surplus funds into prudent AAA-rated financial products.
The Subcommittee was also highly critical of the role of investment banks in contributing to the global financial crisis through risky lending practices. The Subcommittee investigated the practices of Goldman Sachs and Deutsche Bank, two investment banks active in the marketing of high-risk RMBSs and CDOs. Both Goldman Sachs and Deutsche Bank were underwriters and market-makers of various structured financial products, increasing liquidity for willing market participants to buy and sell financial instruments.
The Subcommittee concluded that after examining the practices of Goldman Sachs and Deutsche Bank, “a variety of troubling practices that raise conflicts of interest and other concerns involving RMBS, CDO, CDS and ABX related financial instruments that contributed to the financial crisis.”51 In particular, the Subcommittee’s investigation of Goldman Sachs focused on how the firm “used net short positions to benefit from the downturn in the mortgage market, and designed, marketed and sold CDOs in ways that created conflicts of interest with the firm’s clients and at times led to the bank’s profiting from the same products that caused substantial losses for its clients.”52
The investigations by the Subcommittee regarding the activities of Goldman Sachs and Deutsche Bank in the lead-up to the global financial crisis revealed a number of questionable practices. According to the Subcommittee, both investment banks issued “high risk, poor quality mortgages, and sold risky securities to investors across the United States and around the world.”53 The practices that investment banks engaged in, in the sale and marketing of RMBSs, CDOs and other related structured financial products were not isolated practices. The Subcommittee’s investigation revealed that both Goldman Sachs and Deutsche Bank:
sold CDO securities without full disclosure of the negative views of some of their employees regarding the underlying assets and, in the case of Goldman, without full disclosure that it was shorting the very CDO securities it was marketing, raising questions about whether Goldman complied with its obligations to issue suitable investment recommendations and disclose material adverse interests.54
The activities of Goldman Sachs and Deutsche Bank were also questioned by the Subcommittee, as both investment banks continued to market new CDOs in 2007, at the time when US mortgage defaults began to intensify.55 According to the Subcommittee “both kept producing and selling high risk, poor quality structured finance products in a negative market.”56 In arriving at its conclusion, the Subcommittee was particularly critical of the role of investment banks in the lead-up to the global financial crisis. The Subcommittee concluded that “the investment banks that engineered, sold, traded and profited from mortgage related structured finance products were a major cause of the financial crisis.”57
In proposing recommendations to reform the practices of investment banks, the Subcommittee recommended that federal regulators review the activities of Wall Street banks, including their role in issuing securitized and structured financial products. The purpose of any review would be “to identify any violations of law and to examine ways to strengthen existing regulatory prohibitions against abusive practices involving structured finance products.”58 The Subcommittee further recommended that federal regulators should design and implement stronger conflict-of-interest prohibitions.59