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Re-Regulating
the
Financial System
Mario Tonveronachi and Elisabetta Montanaro
University of Siena, Italy
IDEAs Conference on “Re-regulating global finance in the light of the global crisis”
Tsinghua University, Beijing, China, 9-12 April 2009
Why did “It” happen again?
 Roots:

International financial architecture

Laissez-faire approach to financial regulation
2
International Architecture
 After
the end of Bretton Woods

Dominance of private international finance

Persistent external imbalances are funded with mobile and volatile
capitals

Speculative and ponzi positions  global fragility
3
Fundamentals of Current Regulation
 Laissez-faire

This has been the mayor financial innovation of the last twenty years
 Maniacal

approach to risk-taking
focus on capitalisation
Disregard of the traditional tenets of banking, i.e. liquidity and
provisioning
 Ability
to fine-measure risks (firms) and fine-assess them
(supervisors)

A
Expected and unexpected risks. Fat tails.
market-friendly approach by supervisors

Recent proposals converge on giving even more discretionary
powers to supervisors and to new Global Boards, without changing
the rules of the game
4
Effects on the financial structure
 Liberalisation and de-regulation produced:

Higher financial returns

Enormous increase of financial deepening
5
Financial deepening
Financial deepening and financial multiplier
Development of key financial aggregates, 1970-2007. Deflated by GDP, 1970=100
Averages for Canada, Japan,Uk, US, Germany, Italy and the Netherlands
Sources: 1970-2000, G. Schinasi; 2001-07, R. Traficante
6
Financial pyramid

Expansion of financial assets characterised by:

An increasing pyramid of volatile liquidity

An increasing pyramid of debt
7
Pyramid of Volatile Liquidity

Inverted pyramid ordered in terms of
liquidity of decreasing quality

The growth of assets was concentrated
on the areas of liquidity of lower quality

In Minskyan terms, highly speculative
and ponzi positions dominates the
areas of worse liquidity

Since flight to quality means flight to
better liquidity, an increase of fragility
follows

Pollution of secondary liquidity
produced by the increased contiguity
between banks and markets
Derivatives
Private securities
Secondary liquidity
Public debt
Primary liquidity
8
Financial Pyramid and Debt
 Growth
potential coming from finance exceeds potential growth
coming from real determinants
 Can
finance push real growth to its own level?
 Permanently
no, since it cannot dictate the pace for the determinants
of real growth
 Yes,
for a while, relaxing the liquidity constraints of non-financial
units
 The
rate of growth of aggregate demand accelerates as a
consequence of the growth of indebtedness by non-financial units
9
Financial Pyramid and Debt
 However:


The increasing weight of the debt service steals resources from the
dynamics of aggregate demand
In Minskyan terms, debtors’ margins of safety continuously decrease

When the degree of indebtedness reaches a point where cash flows are
not enough to service the debt, interests are capitalised and the debt
takes an autonomous upward dynamics. Debtors increasingly shift into
ponzi positions

In these conditions the economy structurally requires very low
interest rates

When interest rates required for financial stability become significantly
lower than the rates required for monetary stability, deleveraging and
debt deflation sooner or later necessarily follows
10
Increasing Fragility
Let’s look at the U.S. experience
Components of U.S. Debt/GDP
4
3
2
1
Household
Non Fin Sector
State&Local Govs.
Fed Gov.
2008
2005
2002
1999
1996
1993
1990
1987
1984
1981
1978
1975
1972
1969
1966
1963
1960
1957
1954
1951
1948
1945
0
Financial Sector
11
Increasing Fragility
The US experience suggests an increasing mutual interaction between fragility
and monetary policy
Starting from the mid-80s, the trend of Fed Funds rate has nothing to do with the
trend of inflation
January 1983 - December 1993
%
January 1994 - December 2008
%
12
12
Fed Funds
10
10
8
8
6
6
4
4
Inflation
2
Fed Funds
2
Inflation
2007-4
2006-3
2005-2
2004-1
2002-4
2001-3
2000-2
1999-1
1997-4
1996-3
1995-2
1994-1
1993-1
1992-1
1991-1
1990-1
1989-1
1988-1
1987-1
1986-1
1985-1
1984-1
0
1983-1
0
LEGENDA
- Fed Funds = average quarterly nominal effective rate
- Inflation = CPI quarterly % change on year earlier
12
Increasing Fragility
The trends of Fed’s rate and of % change of GDP are highly related. Fed’s policy is
also responsive to GDP movements
January 1983 - December 1993
%
January 1994 - December 2008
%
14
14
12
GDP %
2
1996-3
1993-1
1992-1
1991-1
1990-1
1989-1
1988-1
1987-1
1986-1
-2
1985-1
-2
1984-1
0
1983-1
0
GDP %
1995-2
2
2007-4
4
2006-3
4
2005-2
6
2004-1
6
Fed Funds
2002-4
8
2001-3
8
2000-2
10
1999-1
10
1997-4
Fed Funds
1994-1
12
LEGENDA
- Fed Funds = average quarterly nominal effective rate
- GDP, % change = quarterly % change on year earlier
13
Increasing Fragility
In the last part of the period assets’ prices enter de facto into Fed’s responses
USA. January 1983 - December 2008
%
14
1600
12
1999-2008
Correlation coefficients
Fed Funds rate versus
Inflation GDP % S&P’s 500
0.31
0.30
0.87
Fed Funds
1400
S&P's 500
10
1200
8
1000
6
800
4
600
2
400
0
200
-2
2008-3
2007-1
2005-3
2004-1
2002-3
2001-1
1999-3
1998-1
1996-3
1995-1
1993-3
1992-1
1990-3
1989-1
1987-3
1986-1
1984-3
1983-1
0
LEGENDA
- Fed Funds = average quarterly nominal effective rate
- S&P's 500 = averge quarterly index at constant prices, CPI January 1959=100
14
Increasing Fragility
 Every time the Fed tried to push interest rates towards ‘normal’ levels it
was obliged to go back, and increasingly so, each time validating more fragile
positions
 Stages: Financial liberalisation and de-regulation increase financial fragility.
Monetary policy validates fragile instruments and positions. Financial fragility
accumulates further, thus increasing the constraint on monetary policy and its
inefficacy. An so on.
 As Jan Kregel aptly commented on the above analysis: “The rescue via low
interest rates validates the fragile financial instruments that are developed in
each phase, and they become built into the system as the frame for even
more fragile instruments and structures”
A long-term Minsky Process was let inflating, which finally exploded in
2008
15
A Radical Change of Perspective

International financial architecture and regulation

Basel’s systemic preconditions. Their inefficacy opens two routes:


Maintain a laissez-faire approach to risk-taking and incorporate macroeconomic
anti-cyclical measures into the existing micro-stability scheme (the solution favoured
by most current proposals)

Adopt a structural approach to regulation in order to transform the same financial
structure into the systemic precondition for stability (our proposal)
We should:

Completely abandon the Basel construction

Over-regulate for at least the next 10-15 years


Simplify regulation, lower its costs and reduce supervisors’ discretionary
powers
Increase the autonomy and responsibility of local jurisdictions over a common
international regulatory base
16
A New Approach


General lines:
 Oppose a rentier-approach to wealth accumulation. This is possible with a
financial structure that does not allow for highly risky financial instruments and
institutions

Regulation must not evaluate fat tails, but must slim them down

Shift from a risk-measurement to a risk-control approach to regulation
We propose to:

Introduce structural measures for avoiding hard-to-value risks, limiting
paper-value financial deepening and the size of intermediaries

Regain focus on margins of safety, particularly on liquidity and provisioning

Re-direct incentives towards a sustainable financing of the real economy
17
Main Features of Our Proposal
Structural Measures

Regulators agree on “a positive list of financial instruments and
institutions. Anything that is not explicitly allowed is forbidden” (Buiter,
2009). Among “institutions” we include organised markets

Hard-to-value and hard–to-manage instruments and intermediaries are
not permitted

Common rules extend to all leveraged financial firms

Regulated institutions are not permitted to have direct or indirect relations
with countries not adopting a basic regulation homogeneous with their
own

Foreign banks are allowed to operate only as subsidiaries
18
Main Features of Our Proposal
Structural Measures
end

Leveraged institutions are not allowed to enter into securities and
derivative contracts not traded in organised secondary markets

Supervisors are obliged to set up clear and binding crisis resolution
procedures for all leveraged institutions

False information to the supervisory authorities and attempts to skim off
value from the institution are considered as corporate fraud and are
subject to criminal prosecution. They thus include all significant
misstatements not only of allowances for credit and portfolio losses, but
also of provisions

Separation of leveraged financial firms from Collective Investment
Schemes (CIS), insurance companies, pension funds and commerce
19
Main Features of Our Proposal
Prudential Measures

All prudential requirements must be observed both on a stand alone and
consolidated basis

Foreign subsidiaries have to met regulatory requirements on a local basis

Fair value accounting is applied neither to the banking nor to the trading
book
 The banking book is evaluated at amortised cost
 The trading book is marked to market
 A specific Reserve the trading book is set up to smooth the effects of
potential gains or losses on the income account
20
Main Features of Our Proposal
Prudential Measures
Capitalisation

Maximum limits to un-weighted leverage ratios are imposed, distinguishing
between banking and trading books

The maximum leverage for the trading book is lower than the one allowed
for the banking book. The trading book is defined in terms of its gross
value, at market prices

Maximum leverage requirements are established in relation to categories
of intermediaries defined in terms of size intervals. Larger the size,
significantly lower is the maximum permitted leverage ratio. The size refers
to consolidated balance-sheets, distinguishing between the banking and
the trading books
21
Main Features of Our Proposal
Prudential Measures
Liquidity

Coefficients to limit maturity mismatches are introduced

Different liquidity requirements for the banking and the trading book

For the banking book the liquidity requirement is an increasing function
both of the value of the book and of the customer funding gap

For the trading book the liquidity requirement is an increasing function of
portfolio’s market value

Liquidity requirements must be met with cash and/or risk-free assets
22
Main Features of Our Proposal
Prudential Measures

Dynamic provisions are introduced as a direct function of interest income.
Fiscal treatment of provisions must follow supervisory rules, and not vice
versa

Lower regulatory requirements coming from risk transfer are admitted only
when risks are integrally shifted to unconnected subjects and no new
obligations are linked to them
23