The following is a submission from Naked Capitalism contributor Swedish Lex.
While some observers of U.S. politics lament the lack of progress in reforming the country’s financial system, the European financial industry has abruptly awoken to the EU’s new resolve re-shape the continent’s financial system. How far and how fast the EU intends to go is still unclear, but the financial Industry is bracing itself for what some of its members fear will degenerate into a wrongheaded bonus-destroying regulatory overkill fiesta. Others regard reform as necessary surgery to restore balance in society, even if it means that the financial industry loses a limb or two in the process.
This guest post will discuss the emerging pattern of initiatives in Europe to regulate finance more and differently in the future. Many of these policy initiatives are being drawn up by the EU Institutions and will be tabled and debated in the coming months and years and are likely to have a substantial impact outside the EU’s borders too.
The EU’s Internal Market for banking and financial services really took off in 1992 and thereafter. Pre-existing national models of financial systems were gradually supplanted or replaced by the new EU-wide version. The EU thus had to import an ideological and conceptual framework to build a common system where no such system had existed before. The EU’s banking and financial services framework is a blend of the collective heritage of the EU states that has been transformed to suit the EU as a whole. However, many of the EU’s core laws found their inspiration across the English Channel and, further on westwards, in the U.S.. The appeal of the Anglo-Saxon model was notable.
Those who disproved of the direction in which matters were going were outnumbered and out of fashion. Moreover, they lacked an alternative vision that promised anything remotely resembling the economic and societal gains that would be created if only the financial sector was allowed to reach its full potential. It all sounded pretty good and consequently it became a prioritized goal to expand the EU’s financial sector as a tool to boost GDP, employment and the Union’s position on the global economic pecking order.
Not everybody agreed, however. The European Parliament, and its group of Socialist parlamentarians in particular, have over a number of years sought to draw the other EU Institutions’ attention to the structural flaws in the EU’s financial architecture and to the lack of foresight and contingency planning to curb systemic risk. It may be reasonable to assume that Socialists due to their ideological preferences are more prone identify flaws in a free-market system than others, but the fact remains that the European Parliament as an Institution was concerned early on that a financial meltdown may occur and therefore used its (limited) constitutional powers under the EC Treaty to force the EC Commission into action. In the competition to determine who first saw the financial crisis coming, whether it was Nouriel Roubini or someone else, I believe that that the European Parliament at least deserves has a special mentioning.
These admittedly lengthy excerpts are from a European Parliament resolution (a form of appeal directed at the EC Commission) are straightforward and strikingly clairvoyant. The Resolution was adopted in January 2004 and concerned the future of hedge funds and derivatives and was thus enacted before the use of derivatives reached the stratosphere and contributed to driving the global economy off a cliff.
R. whereas derivatives are increasingly used in investment products available to the general public and are therefore becoming a relevant consideration in all the directives cited above,
S. whereas, over the last 20 years, derivatives have played a vital role in financial innovation, facilitating the creation of a range of new products (including many low risk products) and widening investor choice,
whereas derivatives can be a means of limiting risk as well as of speculative risk-taking and can provide a macroeconomic benefit by dispersing risk to those best able to accept it,
U. whereas commodity derivatives can play a vital role in hedging risk and ensuring efficient utilization of resources in markets such as energy and agriculture, and whereas their importance can be expected to increase with further liberalisation of energy and agriculture markets,
V. whereas it is imperative that such risk be properly monitored and controlled both as regards the risk to individuals and systemic risk to the financial system,
W. whereas it is important to ensure that the regulation of derivatives is proportionate to the risks they pose for individual investors and for overall financial stability, and whereas it is vital that a wide ranging and effective cost-benefit analysis is carried out before any new laws or rules are added to existing regulation of these financial products,
X. whereas the proliferation of credit derivatives raises issues in terms of tracking global levels of risk exposure,
Y. whereas those OTC (“over-the-counter”) derivatives which are unregulated could build up into a dangerous overhang in financial markets,
Z. whereas the validity of derivatives depends on the certainty of full settlement at maturity and therefore on the credit standing and ability of ultimate counterparties to meet obligations,
AA. whereas sophisticated types of derivatives may be illiquid and therefore holders may have difficulties closing or valuing positions, especially in difficult market conditions,
AB. whereas derivatives are becoming a common mechanism in the financial management of corporations, investment companies and smaller banks and it is necessary for those users to have appropriate competence in controlling risk exposure,
AC. whereas knowledge and competence even among regulatory authorities is often inadequate in this fast moving and ever changing area,
AD. whereas financial derivatives can be marketed to retail investors in various forms, such as listed products and spread betting, provided they are under the scope of national financial regulators,
26. Calls on the Commission in the interests of coherence in securities law to draw together the various relevant items of EU legislation in order to facilitate comprehensive legislative treatment (inter alia) of derivatives;
27. Calls on the Commission to instigate, along with national and relevant international institutions, a means of measuring and monitoring global exposure in derivatives and, in particular, the accumulated credit risk (including settlement risk) of credit derivatives; stresses that only those with appropriate capital cover may deal in derivatives, in order that, in periods of crisis, losses do not have to be borne by taxpayers;
This 2004 Resolution is however only one example in a string of initiatives by the European Parliament to get a better grip on the financial sector. As the title of the Resolution indicates, the Parliament has for a long time had its sights on the systemic risk and societal consequences of hedge funds, private equity and other “sophisticated alternative investment vehicles (SAIVs)”. As the financial crisis began to unfold, the Parliament’s views gained more traction, in particular as the EU States also began to exercise pressure on the EC Commission to draft and table new laws for the financial sector. The EC Commission, which is both the EU’s watchdog and also alone holds the keys to tabling new EU policy and regulatory proposals, largely failed to spot the brewing bubble and the financial disease spreading through the economy. Historians will have to determine to what degree this failure has its explanation in the Commission’s underlying philosophy being that of lighter regulation and the inherent self-correcting powers of the financial system.
Whatever the most appropriate historical conclusion may be, it however appears safe to assume that the EU as a whole and the EC Commission in particular has started a process to re-write its ideological source code and that this profound change probably significantly will impact both the scope and direction of proposals that we should be expecting in the coming months and years. This process will be gradual, non-linear and the result of endless debates and processes in the EU’s sociopolitical universe.
One feature of this ensuing debate is that the direction of future policy choices will be made against a backdrop that is broader in its scope than addressing purely financial matters. The wider systemic and, thus, societal impact of the finance sector will be given a more prominent place in the decision-making process. The previous concept of building a legal and political infrastructure to promote banking and financial services as such, will be given less weight. These quotes by the leader of the Socialist group in the European Parliament and former Prime Minister of Denmark Poul Nyrup Rasmussen given at a conference in Brussels in January provide a good illustration:
“Even if such systemic breakdown is prevented, any form of market stress imposes significant costs on a whole host of other financial institutions and often also the real economy. Importantly, this total cost to the system or to society is much higher than private cost to the institution where the financial stress originates.
So, financial disturbances in a hedge fund (or any other significant financial institution) have significant negative externalities. Such potential negative externalities are perhaps the most important reason to regulate hedge funds and private equity.”
“In any case the benefits of lower systemic risk through better prudential norms would far exceed any potential costs in terms of a loss of competitive edge.
The EU has a leading role to play in promoting a certain convergence among regional regulatory and supervisory frameworks. This will be an important path of the basis for future global regulation.”
Rasmussen’s comments are representative of a growing awareness in Europe that the externalities of modern finance, also when they only are potential, should be guiding policy-makers. Views like these were not unusual before but, as discussed above, clearly in minority. With leading UK and U.S. representatives now contributing to this new current, the momentum to undertake a major overhaul of the EU’s strategy on banking and financial services is gaining traction. Recent statements like these do obviously not go unnoticed in Brussels and in EU capitals:
- Paul Volcker: “Extensive participation in the impersonal, transaction-oriented capital market does not seem to me an intrinsic part of commercial banking,” “banks should be banned from “sponsoring and capitalizing” hedge funds and private-equity firms, which are largely unregulated.” “particularly strict supervision, with strong capital and collateral requirements, should be directed toward limiting proprietary securities and derivatives trading.”
- Lord Turner: “We cannot go back to business as usual and accept the risk that a similar crisis occurs again in ten or 20 years’ time. We need radical change. Regulators must design radically changed regulations and supervisory approaches, but we also need to challenge our entire past philosophy of regulation. And parts of the financial services industries need to reflect deeply on their role in the economy, and to recommit to a focus on their essential social and economic functions, if they are to regain public trust.”
The stimuli thus reaching the EU’s policy architects is thus clear and unequivocal; create an environment for financial markets that must effectively contain potential externalities, even if that means a clear break with current practices. A recent blog post – Regulation in Defense of Capitalism – provided a succinct overview of the case of properly accounting for the externalities of finance (“Wall Street’s toxic sludge”):
“Regulation that exposes these costs and forces the trader or bank to absorb them makes the markets more true to capitalist ideals. Capitalist regulation forces the producers to recognize all of their costs. It undoes the harm to capitalism that comes from limited liability and its kissing cousins, the trader’s option and short term compensation deals. The flip side is that with capitalist regulation, no one can take on more risk than they are capable of absorbing. Which means requiring higher levels of capital on the one hand, restricting leverage on the other, which in turn means reduced capacity to generate high returns.”
An extended application of an equivalent of the polluter pays principle (PPP), that governs most of the EU’s environmental laws, into the world of banking and financial services constitutes a not too unlikely scenario when trying to figure out in which direction the EU eventually will choose to go.
An edifying and recent case where the EU undertook a fundamental overhaul of all regulation applicable to a whole Industry, in order to ensure that its externalities were properly accounted for, exists in the area of chemicals. The EU a few years back adopted entirely new and far-reaching regulation of chemicals. That legislative package (REACH), one of the EU’s most ambitious pieces of legislation ever.
It is possible, although I would not say likely at this point, that banking and financial services, like their chemical industry peers, are about to experience the biggest change to their industry, perhaps ever, if a scenario analogous to that of REACH becomes reality. This excerpt from an article in the Washington Post published at the time of the adoption of REACH is long but captures the potential outcome for the banking and financial industries 3-5 years down the road:
“The Washington Post
WASHINGTON — Europe this month rolled out new restrictions on makers of chemicals linked to cancer and other health problems, changes that are forcing U.S. industries to find new ways to produce a wide range of everyday products.
The new laws in the European Union (EU) require companies to demonstrate that a chemical is safe before it enters commerce, the opposite of policies in the United States, where regulators must prove a chemical is harmful before it can be restricted or removed from the market. Manufacturers said complying with the European laws will add billions to their costs.
The changes come as consumers increasingly are worried about the long-term consequences of chemical exposure and are agitating for more aggressive regulation. In the United States, these pressures have spurred efforts in Congress and some state legislatures to pass laws that would circumvent the laborious federal regulatory process.
The EU laws, opposed by the U.S. chemical industry and the Bush administration, will be phased in over the next decade. It is difficult to know how the changes will affect products for sale in the United States. But U.S. manufacturers are searching for safer alternatives to chemicals used to manufacture thousands of consumer goods, from bike helmets to shower curtains.
The EU’s stance on chemical regulation is the latest area in which the Europeans are reshaping business practices with demands that U.S. companies either comply or lose access to a market of 27 countries and nearly 500 million people.
From its crackdown on antitrust practices in the computer industry to its rigorous protection of consumer privacy, the EU has adopted a regulatory philosophy that emphasizes the consumer.
Its approach to managing chemical risks is part of a European focus on caution when it comes to health and the environment.
“There’s a strong sense in Europe and the world at large that America is letting the market have a free ride,” said Sheila Jasanoff, professor of science and technology studies at Harvard University’s John F. Kennedy School of Government.
Under the EU laws, manufacturers must study and report the risks posed by specific chemicals. Through the Internet, the data will be available for the first time to consumers, regulators and potential litigants around the world. Until now, much of that information either did not exist or was closely held by companies.
“This is going to compel companies to be more responsible for their products than they have ever been,” said Daryl Ditz, senior policy adviser at the Center for International Environmental Law.
The laws also call for the EU to create a list of “substances of very high concern,” those suspected of causing cancer or other health problems. Any manufacturer wishing to produce or sell a chemical on that list must receive special authorization.”
“The EU standards will force many manufacturers to reformulate their products for sale there and in the U.S. “We’re not looking at this as a European program; we’re buying and selling all over the globe,” said Linda Fisher, vice president and chief sustainability officer for DuPont and a former EPA deputy administrator.”
During the adoption phase of REACH, the industry threw everything it had into the lobbying campaign to thwart and water down the initiative. Arguments were made that European firms would; lose in competitiveness, have to raise prices, be forced to shed jobs, not be able to afford innovation and that protectionist barriers would be raised vis-à-vis third countries as result. Impact assessments were made on both sides of the debate and it was clear that the legislation would result in billions in extra costs for the industry. In the end, however, the EU Institutions and the Member States, after certain concessions to the chemicals industry, pushed through with legislation.
The U.S. (federal and state levels), and other countries, are not is now debating or introducing measures modeled on REACH.
If the EU Institutions conclude that the same kind of radical (to use Lord Turner’s terminology) reforms are necessary for the financial sector, will they have the clout to enact them into laws against the will of; the Industry, some Member States, including the UK, and Uncle Sam? Perhaps not. But should the European economy continue to disappoint in the coming years as result of the toxins on (and off) the balance sheets of the financial groups, it is possible that sufficient political momentum will be maintained for truly radical reforms to be enacted.
A central factor that will influence in which direction and how for the EU will go with its reform measures is the new top management of the EC Commission that is in the process of being appointed for a five-year term. The current President, Barroso, has been confirmed and had to make pledges to both the EU States and the European Parliament for far-reaching financial reform in order to be reelected. The reform-hungry will be watching every step he takes. Meanwhile, Germany and France are reported both to be demanding for the bank and financial services portfolio for their respective commissioners. Since the job description nowadays clearly states that candidates with an Anglo-Saxon outlook need not apply, the ideology and focus EU’s next bank chief may well come as une grande surprise to many.
Concerning the future of hedge funds and derivatives
Regulation in Defense of Capitalism