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The First Network Crisis of the 21st Century: A Regulatory Post-Mortem

The current financial crisis should be viewed as a network crisis, because due to a whole series of deregulation measures, financial reforms and technological and financial innovations, the world has become closely networked into a global market, with laws, and policies functioning within national boundaries. This essay points out that the increased integration of the global market today brooks no further postponement of major reforms. The risk is that if sound, transparent and effective regulation is not built into the international financial architecture to foster open trade in goods and services, emerging markets would neither have the confidence for investment abroad, nor would they have the confidence to open their markets to higher volatility and contagion risks. This crisis therefore is likely to trigger considerable changes in the way we think about the behaviour of markets and the proper role of regulation and governments, particularly in crisis management. What is needed is a dynamic, evolutionary, interactive, and holistic understanding of how complex markets evolve and mutate.


The First Network Crisis of the 21st Century: A Regulatory Post-Mortem

Andrew Sheng

The current financial crisis should be viewed as a network crisis, because due to a whole series of deregulation measures, financial reforms and technological and financial innovations, the world has become closely networked into a global market, with laws, and policies functioning within national boundaries. This essay points out that the increased integration of the global market today brooks no further postponement of major reforms. The risk is that if sound, transparent and effective regulation is not built into the international financial architecture to foster open trade in goods and services, emerging markets would neither have the confidence for investment abroad, nor would they have the confidence to open their markets to higher volatility and contagion risks. This crisis therefore is likely to trigger considerable changes in the way we think about the behaviour of markets and the proper role of regulation and governments, particularly in crisis management.What is needed is a dynamic, evolutionary, interactive, and holistic understanding of how complex markets evolve and mutate.

Andrew Sheng ( is Adjunct Professor, Tsinghua University, Beijing and University of Malaya, Kuala Lumpur.

s the current global financial and economic crisis moves into its second year, it is timely to conduct a post-mortem of what went wrong and what to do to prevent the next financial crisis. My analysis of what went wrong at the historical, macro and micro levels is contained in the third Lall Memorial lecture, and so this paper will concentrate on the issues at the financial regulation front.

Recently, there has been a spate of excellent reviews of what went wrong in financial regulation. These would include reports by the Group of Thirty (2009), the Geneva Group and the recent report by the de Larosiere Group (2009). These reports, especially the latter two, are much more frank and constructive than earlier reports and recommendations of various official supervisory bodies, which tended to be defensive, highly technical and seemed to suggest that if only more of the same were done, things would improve for the better.

There is now increasing recognition that the nature of the current crisis is profoundly different in many ways and that radical approaches and tools will have to be used. The latest International Monetary Fund (IMF) analysis (February 2009), for example, considers that the root causes of the current crisis lay in

market failure... bred by a long period of high growth, low real interest rates and volatility and policy failures in financial regulation – which was not equipped to see the risk concentrations and flawed incentives behind the financial innovation boom; macroeconomic policies – which did not take into account building systemic risks in the financial system and in housing markets; and global architecture – where a fragmented surveillance system compounded the inability to see growing vulnerabilities and links.

In Sheng (forthcoming), I have tried to explain that the current crisis should be viewed as a network crisis, because due to a whole series of deregulation, financial reforms and technological and financial innovations, the world has become closely networked into a global market, with laws, regulation and policies functioning within national boundaries. Current policymakers and regulators, mostly economists, lawyers or accountants by training, have not borrowed enough from other disciplines, such as information technology, engineering, biology and psychology to recognise that words such as incentives, concentration, volatility and architecture are also used widely to describe and control network behaviour. It is the mindset that solutions at microinstitutional level would naturally lead to stability of the whole that was flawed.

For example, one of the first “laws” to describe network behaviour is Metcalfe’s Law, which postulates that the value of a network goes up as the square of the number of users. The widespread belief

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that the wider the network, the larger the economies of scale and efficiency has driven traditionally segregated networks of banking, insurance, securities and pension funds together. Since the 1990s, it was the fashion of the larger banks and insurance companies to become financial Wal-Marts, providing one-stop financial services to consumers, corporates and investors. There was a flurry of mergers and acquisitions both vertically and horizontally, so that today, not more than 30 to 50 large, complex financial institution (LCFI) groups control up to half of global financial services businesses, particularly in financial derivatives trade. Such agglomeration and concentration is also observed in other network industries, such as telecommunications, airlines and software.

Network Advantages and Disadvantages

Network linkages through economies of scale, capital efficiency and reduction of transaction costs were driven and encouraged by the free market philosophy that drove global financial deregulation, liberalisation of trade and capital accounts, reduction of taxation and transaction taxes and the push for globalisation. With gradual harmonisation of practices and standards, globalisation was created by the four mega-trends of arbitrages in labour wages, interest rates, knowledge and regulation. Trade volume increased and those economies that protected property rights, lowered transaction costs with high transparency and comparative advantage in skills, technology and governance benefited from globalisation.

In essence, we have arrived at a global network where information and funds can be transferred with the speed of light, but mindsets, laws and regulations are compartmentalised within national borders. The present regulatory architecture is highly archaic. In terms of size, many national regulators forget that the LCFIs are larger than their national gross domestic products (GDPs) and yet, the banks of a small island economy like Iceland could have an external debt seven times larger than its GDP and their failure could have huge impact on global depositors.

The four global arbitrages initially created a period of high growth, apparent price stability, low volatility and rising prosperity, but policymakers and the public alike underestimated the rise of the four excesses in liquidity, leverage, confidence and then greed. As Keynesian economist Hyman Minsky predicted, stability creates instability. Flush with success, the network vulnerabilities and risks from conflicts of interest, market concentration, connected lending, risk opacity, contagion and difficulties of monitoring behaviour were downplayed or overlooked, as it was felt that self-interest, self-regulation and market competition would ensure growing prosperity with financial stability. Moreover, it was felt that central banks had the tools to limit the damage from the cyclical downturn and banks had adequate capital and sophisticated risk management models and tools.

Unfortunately, as we subsequently found out, all four lines of defence for financial stability failed. The first line of defence at the board, bank management and internal controls failed to prevent leading banks from taking on too much risk. The second line of defence of auditors, legal advisers and rating agencies did not stop and check the risks building up in toxic products, excessive remunerations or at the counterparty levels. Risk management experts may have helped sustain mistaken beliefs that all was manageable. The third line of defence by financial regulators, standard-setters and central banks in charge of financial stability grossly underestimated the systemic impact of the crisis and were caught with ad hoc and uncoordinated crisis responses that did not help market confidence. Likewise, the final line of defence of market discipline, including the media and public opinion, was if anything more pro-cyclical than anti-cyclical. It was an unmitigated disaster.

The de Larosiere Group Analysis

Common with the IMF and other analyses, the de Larosiere Report attributed the causes of the crisis to macroeconomic issues, fundamental failures in assessment of risks, the role of rating agencies, corporate governance failures and the failures of regulatory, supervisory and crisis management.

By and large, there was general consensus that current regulation and supervisory practices failed to mitigate the recent cycle in leverage, credit expansion and housing prices; little was done to tighten regulations in the upswing, nor to mitigate or reverse the pro-cyclical implications of the accounting/regulatory framework in the downturn. Indeed, financial oversight and enforcement provided little or no check to the risky decisions made by financial institutions due to excessive compensation schemes and regulation had not evolved sufficiently to the profound changes (and underlying vulnerabilities) in the financial industry.

The de Larosiere Report specifically castigated the following regulatory failures:

  • Regulated financial institutions have turned out to be the largest source of problems;
  • Insufficient attention was given to the liquidity of markets, with real problems of information exchange and collective decisionmaking involving central banks, supervisors and finance ministries;
  • European Union (EU) supervisors “failed to spot the degree to which a number of EU financial institutions had accumulated – often in off-balance sheet constructions – exceptionally high exposure to highly complex, later to become illiquid financial assets”;
  • Serious limitations in the existing supervisory framework globally, both in a national and cross-border context... financial supervisors frequently did not have and in some cases did not insist in getting, or received too late, all the relevant information on the global magnitude of the excess leveraging; that they did not fully understand or evaluate the size of the risks; and that they did not seem to share their information properly with their counterparts in other member states or with the US;
  • Regulators and supervisors focused on the micro-prudential supervision of individual institutions and not sufficiently on the macro-systemic risks of a contagion of correlated horizontal shocks. Strong international competition among international financial centres also contributed to national regulators and supervisors being reluctant to take unilateral action;
  • While the building up of imbalances and risks was widely acknow ledged and commented upon, there was little consensus among policymakers or regulators at the highest level on the seriousness of the problem, or on the measures to be taken. There was little impact of early warning in terms of action – and most early warning systems were feeble anyway; and
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    – Multilateral surveillance (IMF) did not function efficiently, as it did not lead to a timely correction of macroeconomic imbalances and exchange rate misalignments. Nor did concerns about the stability of the international financial system lead to sufficient coordinated action, for example through the IMF, Financial Stability Forum (FSF), Group of Eight (G8) or anywhere else.

    A Network Analysis of the Crisis

    The above analyses actually describe the essential characteristics of network behaviour. Since the global financial market can be seen as a network of national networks, there are several features that deserve more attention. Any solution or reform to prevent the next crisis must resolve the following core network problems revealed by the current crisis, namely, silos of supervision; increasing complexity of financial instruments and the system; complex interconnectivity within the system; large interactive feedback and spillover effects; lack of transparency; the bad incentive mechanisms that encourage excessive risk taking; and finally, ambiguity of responsibility between home and host authorities.

    Before we go into the complexities of the current crisis, we should reflect on the three simple solutions found by the Roosevelt administration in dealing with the aftermath of Great Depression: net capital rule, Glass-Steagall and disclosure, namely risk limits, firewalls and greater transparency. The simplicity and elegance of these simple rules were not wrong – net capital rules limited the leverage that each institution could accumulate; Glass-Steagall created the firewall between two different classes of business to prevent contagion; and standardised, centralised information disclosed by all businesses and financial institutions provided the public good for individuals to manage their own risks and decisions.

    Indeed, since the 1930s, the gradual erosion of these “coarse” (Bookstaber 1999) rules created huge opportunities for regulatory arbitrage, so that these rules lost their effectiveness in risk containment. We shall now examine the adequacy of the present regulatory system – the rules, structure, tools and processes – in that light. The rules are necessarily “coarse” because only simple, bright-line rules can be used effectively to stop bad behaviour in complex networks, as explained in detail later.

    1 System-wide View of Networks

    There is now consensus that we can no longer regulate complex networks of financial markets through different silos or segmented views/scope of regulation. Systemic risks emanate from the weakest or most under-regulated parts of the network, and we understand very little about the interconnectivity or interactivity of contagion. Broadly, there should be coherent appropriate oversight of all financial institutions, markets and activities, consistent with their risks.

    Global imbalances and excess liquidity occurred because we have one global market of financial flows and yet no single central bank to conduct appropriate policy responses. Since each national central bank acts for its own national interests, the sum of their individual actions may not have the desired global policy outcomes.

    Similarly, within national borders, the fact that different financial services and institutions are regulated by different

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    regulators means that the spillover effects of systemic behaviour that cut across jurisdictions and markets are not always captured or monitored.

    Hence, the Group of Thirty was surely correct in its Core Recommendation I that “Gaps and weaknesses in the coverage of prudential regulation and supervision must be eliminated. All systemically significant financial institutions, regardless of type, must be subject to an appropriate degree of prudential oversight” (Group of Thirty 2009: 8).

    2 Complexity

    The world is inherently complex and we try to understand complexity through relatively simple theories that may ultimately prove to be wrong. The most obvious examples are the simplistic assumptions built into current risk management Value at Risk (VaR) models, which omit to take into account the “Black Swan” effects of rare events that could be devastating.

    If the two core issues of all social institutions are the Principal-Agent Problem and Information Asymmetry, then complexity is the mechanism by which the agent can take advantage of the principal through increasing information asymmetry. The greater the information asymmetry or complexity, the greater is the lack of accountability and possibility of the agent cheating the principal. In contrast, the principal can make the agent more accountable and align both interests through simple transparent rules that are easily enforceable.

    At the heart of the issue is the incentive for agents to make situations more complex so that they become less accountable and more profitable at the expense of the principal. In the financial sector, the agents are the financial intermediaries, and unfortunately, the regulatory system failed to act on behalf of the principal, the public at large. Private gain was achieved at huge public costs.

    In other words, in a situation of order, disorder wins, while in a situation of disorder, order wins. The conclusion from this analysis is that we cannot solve a crisis through adding complexity, but should try to resolve it through identifying and simplifying rules and enforcing these rigorously.

    We should make the principles-based rules simpler, so that even laymen and emerging markets can understand what is going on and how to behave to protect their own interests. The oversophistication of derivative markets has proven that too complex systems make it possible for systemic risks to concentrate without investors, intermediaries and regulators understanding them. You cannot solve complexity by adding com plexity. There are still too many overlapping regulatory standards with duplication and gaps. For example, there are many areas of overlaps and gaps between Basel Accord Principles for banks, International Organisation of Securities Commissions (IOSCO) Core Principles for securities firms and International Association of Insurance Supervisors (IAIS) Principles for insurance companies, which further overlap with the Organisation of Economic Cooperation and Development (OECD) Corporate Governance Principles.

    As Hedge fund risk manager Richard Bookstaber pointed out in his Congressional testimony, “If the potential for systemic risk stems from market complexity, adding layers of regulation might actually make matters worse by increasing the overall complexity of the financial


    system” (Testimony submitted to the House Financial Services Committee on Systemic Risks: Examining Regulators’ Ability to Respond to Threats to the Financial System, 2 October 2007).

    3 Interconnectivity

    Interconnectivity between institutions, markets and systems lie in the spillover or externalities inherent in products, institutions and activities. The Geneva Report identifies at least five reasons for negative externalities, such as pure informational contagion, loss of access to funding for bank customers, high interaction between banks, fire-sale externality and finally deleveraging externality on the real sector (Geneva Report 2009: 3-9).

    It should be noted that network interconnectivity is not simple or through mutually exclusive channels, but through highly complex interrelationships that are not always fully understood or observable.

    We do not as yet have a good understanding of how contagion can spread through not just direct connections (such as physical networks), but also indirect connections (such as sharing similar software) or even reputational connections. For example, most policymakers initially underestimated the contagion of the Asian financial crisis when Thailand devalued its baht in July 1997, but it was clear that there was contagion to almost all emerging markets as investors fled east Asian stocks and bonds as an asset class. Similarly, the trigger for Long-Term Capital Management’s (LTCM) failure was default in the Russian debt market, a market where LTCM had little exposure (Bookstaber 2007), but the very fact that one market is under stress, you sell what you can sell and therefore the selling pressure spreads to what appears to be other unconnected markets.

    Interconnectivity means that the regulator as well as the financial institution would need to have very different management information systems (MIS) that can detect connections and risks that are not apparent from traditional MIS models. For example, most banks do not have very good information on their counter-parties, especially whether different counter-parties are either affiliated or interconnected in different manners. As an illustration, if an investor dealt with different unrelated hedge funds, but had not realised that they all used Lehman Brothers as their prime broker, the failure of Lehman could subject the investor to huge risks as its hedge funds suffered losses due to Lehman exposures.

    How the information on interconnectivity is established, analysed and then controlled remains a huge challenge for both IT systems and risk management and governance systems.

    4 Interactivity of Negative and Positive Feedbacks

    A common characteristic of network behaviour is the existence of negative and positive feedback loops, which exist because of information asymmetry, leads and lags in behaviour between transactors in network transactions and differences in transaction costs. George Soros (1998) calls this feedback interactivity reflexivity and argues that current neoclassical theory assumes that markets tend towards equilibrium, whereas the presence of feedback loops explains cyclical behaviour in markets. As market activity gathers momentum, information bias and herd behaviour occur and drive the market in larger and larger oscillations.


    The risk of feedback loops is whether such cyclical behaviour creates what Soros calls the “wrecking ball effect,” when positive feedbacks get larger and larger in a chain reaction or selfreinforcing loop that ultimately damages the whole system. Neoclassical theory assumes that there is negative feedback, whereby divergences from the mean dampen over time towards equilibrium (Umpleby 2009). The real concern of regulators therefore is not whether such pro-cyclicality exists, but whether there are tools to dampen or stop the damage from such market volatility. The current recommendations to stop pro-cyclicality tend to be focused on the removal of pro-cyclical tendencies in accounting and regulatory standards, such as mark-to-market accounting, Basel Capital Accord and dynamic loan provisioning requirements.

    If positive feedback is inherent in network behaviour, then the assumption of market fundamentalists that the markets will self adjust towards equilibrium would be wrong. The market fundamentalist view that markets are self-regulatory is true only if all feedback is negative. But the presence of positive feedback, which is an empirical observation, means that markets have to be regulated by limits, firewalls and improved transparency, as discovered in the 1930s.

    In other words, regulators would not only have to put in net capital limits to limit leverage, Glass-Steagall type firewalls to segregate markets from contagion, but also take anti-cyclical action such as tougher enforcement, dynamic provisioning and lowering loan-to-value margin ratios to limit the possible damage from growing positive feedbacks.

    There is therefore an inherent behavioural difference in mindset between a market fundamentalist financial regulator and an old-fashioned regulator who has a long memory of market cycles. The market fundamentalist regulator believes in being marketfriendly, minimal interference in markets, low regulatory costs and the efficacy of market self-interest. The result is that the market fundamentalist regulator is loath to intervene when the market moves into a bubble. The old-fashioned financial regulator understands that roughly every 10 years or so, the market gets into a bubbly mood and that herd behaviour is likely to put financial institutions at risk. Hence, when the old-fashioned regulator reads from his experience that the market is prone to such risks, he has to take anti-cyclical action that limits the possible future damage, and also enforcement action that warns market players that the regulators are vigilant and on the watch for excessive behaviour that is likely to cause market problems.

    5 Transparency

    Transparency refers to a process by which information about existing conditions, decisions and actions is made accessible, visible and understandable to market participants. The strange thing about the current crisis is that it happened in full transparency and completely in front of everyone. The reforms made after the Asian and dotcom crises made more information accessible and visible, with major reforms in accounting and corporate disclosure. Currently, full risk warning and information is disclosed on the web sites of Lehman, AIG, the US Federal Reserve, the Bank of England, European Central Bank and the IMF, but the crisis still happened.

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    Everyone also agrees that the roots of the crisis are so complicated that almost no one understood where to begin to stop the crisis. There was not lack of information, but too much information that was not understandable. Financial derivatives such as collatralised debt obligations (CDOs), credit default swaps (CDS) and conduits were so complicated that neither investors, the originating and selling banks, nor financial regulators understood their complexity and toxicity. So would more rules on transparency help? I doubt it.

    Thus, to argue for more transparency is not enough. Who can argue for a better sunshine policy, where information is readily available for people to judge for themselves whether they have made the right decisions? Transparency can be highly opaque, as former Federal Reserve Chairman Alan Greenspan brilliantly put it, “If I turn out to be particularly clear, you’ve probably misunderstood what I’ve said.” Notice that after he stepped down from public office, his comments in the press are very clear on what his views are and what his successors should be doing to clean up the mess.

    In practice, transparency has become a game of information overload so that the receiver is either misled or would not want to admit that he either does not understand or does not know what to do with most of the information. The result is that with the legal requirement to have full disclosure, companies and financial institutions supported by their expensive lawyers learn how to disclose so much information and risks that they are responsible for nothing when anything goes wrong. The truth will be buried in fine print, but only if you know how to find it.

    The leading advocate of disclosure-based regulation is the US Securities and Exchange Commission (SEC), which was founded in 1934 after the Great Depression to protect investors through higher disclosure. In the same year, the Glass-Steagall Act was enacted to separate banking from securities markets and a net capital rule that capped securities broker firm’s liabilities at 15 times capital. This was to ensure that broker firms did not become too highly leveraged that they could not meet their obligations. In 2004, the SEC relaxed this net capital rule for large investment banks with more than $5 billion in equity, by allo wing them to use their own internal risk management models to assess their capital requirements. The 152-page, nearly 50,000-word document released by the SEC needed trained lawyers to read and understand what really went on. It basically said that broker firms (essentially the five investment banks) that adopted the new rule would be “subject to enhanced net capital, early warning, recordkeeping, reporting and certain other requirements, and must implement and document an internal risk management system”. A new condition was that the broker’s ultimate holding company and affiliates would be subject to group-wide SEC supervision and examination, and they had to broadly follow capital adequate standards adopted by the Basel Committee on Banking Supervision.

    Whether the relaxation of the net capital rule allowed the leverage of investment banks to be excessive is still in debate, but it is a fact that after the rule change, investment banks in their previous form disappeared.

    Therefore, instead of making a complex system more complex, and adding more regulation to already complex rules, we should try to make things more simple and understandable. Even 2,500

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    years ago, the Chinese legalist philosophers and bureaucrats understood that laws should be made simple, easily understood, easy to learn and easy to implement and enforcement.

    There is, therefore, a movement to improve consumer financial literacy and investor education. Investor education can only be effective when the regulators and the businesses explain clearly and simply what the risks are and then practise what they promise. Action will speak louder than words. Improving investor education and financial intermediary and regulators’ professional education are therefore necessary but not sufficient conditions for improving general understanding of market risks. Nevertheless, you can bring a horse to water, but cannot force it to drink. Hence, an important issue is the question of incentives.

    6 Incentives

    There is general consensus that current management compensation schemes were excessive and could have led to short-term excessive risk-taking. However, not enough attention has been paid to why there were no incentives for boards of directors, auditors, rating agencies, regulators and policymakers to act anti-cyclically more effectively and forcefully.

    The issue of pro-cyclicality was keenly debated in the international financial community. As early as 2004, the IMF and the Hong Kong Institute of Monetary Research held a seminar to discuss the procyclicality of financial systems in Asia. IMF research found from the Asian experience that property prices are strongly correlated with both credit and real GDP growth and that downturns are much sharper than upturns, reflecting the role of financial crises in driving excessive pro-cyclicality. Bank of Thailand governor Tarisa Watanagase rightly asked how existing regulatory policies and supervisory practices could be modified to counter procyclical tendencies in the banking sector. She argued that policymakers should use a “more activist” prudential agenda to combat procyclical concerns, since “the banking system is too important for emerging market economies to take a more subtle “wait and see” approach to this endeavour” (Watanagase 2006: 132). On what can be done, Reserve Bank of Australia Governor Glenn Stevens argued that an appropriate mix of policies is necessary, covering improvements in regulations, corporate governance and disclosure to strengthen the foundations of financial systems. These need to be combined with more proactive prudential and monetary policies (Lowe and Stevens 2006: 136). However, no answer was given as to what the incentives are to ensure that policymakers are proactive in acting anti-cyclically.

    As evidenced by the crisis, self-discipline did not help to resolve the problems of principal-agency and information asymmetry. That is why we need to strengthen the “trust but validate” function of external supervision. As a check-and-balance to the current “comply and explain” approach, appropriate control mechanisms should be built into the supervision system to ensure that independent quality assurance is conducted on a regular basis.

    Although no report has so far explicitly considered this issue, it would be relevant to ask whether the market fundamentalist approach that called for minimal market intervention was easily prone to regulatory capture. While it is important for regulators to ensure that industry and the legislature is appropriately


    consulted on all regulatory changes, it is important to ensure that supervisory and enforcement action are independently executed to avoid perception that the regulatory system basically favours the financial industry at the expense of the public.

    Herein perhaps lies the conflict between self-interest and the public interest. Given that the market is booming and everyone seems to be happy although risks appear to be rising, it is a strong and self-confident policymaker or regulator who would dare to impose strong anti-cyclical measures that are likely to be extremely unpopular with the industry, politicians and even investors. It is not self-evident that risk-adverse policymakers and regulators will take on huge personal risks to act in the public interest. Perhaps, the psychology of all professionals is what John Maynard Keynes observed: it is less painful to fail conventionally than to succeed unconventionally. No one wants to be the unpopular whistle-blower or the central banker who takes away the punch bowl just as the party gets interesting.

    The prudent or risk-adverse approach is to “wait and see” or try to get more concrete information confirming the risks. The existing risk management models have not helped prompt decisionmaking or action by having neither the long data series nor the completeness of technical analysis to forewarn against the dire consequences of crisis. As the de Larosiere Report also alluded to, competition for international financial centre business also caused regulators and policymakers to avoid making tough decisions that would drive away business to other centres. The incentives instead pointed towards regulatory arbitrage in a race to the bottom.

    There are, therefore, some suggestions that there should be independent bodies responsible for financial stability that have the explicit mandate to “blow the whistle” and to force financial regulators, industry and policymakers to some action. Whether the authorities will listen or respond with the proverbial “this time it is different” remains to be seen. The dilemma with collective responsibility for financial stability is that in reality no one is responsible or accountable.

    7 Division of Labour between Home and Host Regulators

    The growing consensus that the scope of regulation should cover the whole perimeter of systemically important financial institutions and activities means we have to define what is systemic and who should do what. The present crisis has demonstrated that risk concentrations can rapidly emerge from unregulated black holes or under-regulated “shadow banking” areas where managers, regulators and policymakers have little or no information on what is going on. Hence, there is general agreement that regulation should be made more consistent and supervisory oversight and

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    enforcement should be converging toward international standards of best practices. This is more easily said than done.

    First, what is not systemic in a mature market can be highly systemic in an emerging market. For example, a hedge fund that is not systemically important in a mature large home market can indeed be very systemic in an emerging market, especially when it can act in concert with other hedge funds in the unregulated over the counter (OTC) market. The issue is not just about systemic size of trading or exposure, but also relates to mis-selling, market manipulation, insider dealing and fraud.

    Second, we have discovered that what was thought to be nonsystemic can rapidly evolve to become highly systemic. The speed of evolution of toxic viruses such as SARS demonstrated dramatically that health officials need to be vigilant on many fronts. Similarly, the rapid collapse of the liquidity of the secondary market in asset-backed securities caught most regulators by surprise.

    Third, as long as a financial institution or activity is not supervised in its home territory, and without the cooperation and legal authority of the home authority, it would be impossible for the host authority to obtain the necessary information to assess systemic implications or to take investigation and enforcement action, when trading activities can involve several markets and also OTC or unregulated markets. Without effective international cooperation, no host regulator can protect host country investors and counterparties.

    Fourth, the present memorandum of understanding between home and host regulators do not have sufficient legal standing or powers of mediation in the event of disagreements of views between home and host regulators.

    Indeed, the questions raised by the de Larosiere Report on important supervisory failures within the EU are directly applicable to the international arena. These include (de Larosiere Report 2009: 39-41):

  • Too much emphasis on supervision of individual firms and too little on the macro-prudential side;
  • Ineffective early warning mechanisms, especially no mechanisms to ensure that assessments of risks are translated into action
  • Problems of competences – the failure of oversight points to the need for well-staffed, experienced and well-trained supervisors in all states; – Failures to challenge supervisory practices on a cross-border basis – there is no mechanism to enable host countries to effectively challenge the decisions of home regulators who fail to recognise risks;
  • Lack of frankness and cooperation between supervisors – supervisors in different states were not prepared to discuss with appropriate frankness and at an early stage the vulnerabilities of financial institutions which they supervised;
  • Lack of consistent supervisory powers between member states
  • these differences, including differences in insolvency laws, would require changes in law; and
  • No means for supervisors to take common decision – this may be due to lack of legal powers to take decisions or the inability to reach coordinated responses within nations and also with cross-border counterparties.
  • Conclusions

    As can be seen even from this brief survey, the increased integration of the global market today allows no further postponement of major reforms. There are no easy answers, since the global network with segmented and fragmented laws and oversight will be complex to monitor and manage. If it is difficult for a legally constituted group with ample resources like the EU to manage, how much more difficult would it be for many emerging markets?

    This is truly a momentous crisis of the network economy and globalisation. If the international architecture is not reformed and no equitable solution found on a democratic and legitimate basis, then the world will go through another round of protectionism and nationalism that plunged the world into the Great Depression. Globalisation has truly networked developed and developing markets alike, bound in their common interests, since emerging markets have much to lose from their savings in mature markets, just as mature markets benefit from trade and investments in the developing world. The risk is that if sound, transparent and effective regulation is not built into the international financial architecture to foster open trade in goods and services, emerging markets would neither have the confidence for investment abroad, nor would they have the confidence to open their markets to higher market volatility and contagion risks.

    This crisis therefore is likely to trigger considerable changes in the way we think about the behaviour of markets and the proper role of regulation and governments, particularly in crisis management. All we know is that the recent static, segmented, linear and “equilibrium” ways of looking at markets will have to give way to dynamic, evolutionary, interactive, complex and holistic ways of examining how complex markets evolve and mutate.

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    mand: A Parallel” in David Mayes, Robert Pringle and Paul Gruenwald (ed.), Procyclicality of and Michael Taylor (ed.), Toward a New cial Systems in Asia (International Monetary Fund Group of Thirty (2009): Report on Financial Reform, Framework for Financial Stability, Central Bank and Hong Kong Institute for Monetary Research,

    www.group30/pubs/reform report.pdf, January 2009. Publications. Palgrave Macmillan).

    Economic & Political Weekly

    MARCH 28, 2009 vol xliv no 13

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