The ongoing international financial crisis should compel everybody to reexamine financial regulatory frameworks. Some are tempted to see the crisis as a recurrent accident, albeit more severe, along an economic cycle and following worldwide very cheap credit for several years in a row. But a careful reading would go at structural roots of the crisis.

Globalization of financial markets and very intense financial innovation, with precarious and, sometimes, missing regulations, and a plethora of conflicts of interest, have created the milieu for the current crisis. There is a growing debate among top policy makers on how to address the causes of this crisis. One type of arguments refers to cooperation among supervisory agencies. Thus, the Italian minister Tommaso Padoa-Schioppa makes a cogent argument when he advocates the setting up of a single European rulebook and an integrated supervision of EU-wide groups. In my view, these proposals deserve a more sympathetic hearing from his ECOFIN colleagues and EU governments. As a matter of fact, the logic of the single market and increasing cross-border operations ask for increased cooperation among supervisory authorities in the EU. But, arguably, it is not sufficient to focus on strengthening the supervision of banking institutions. For, apart from an irresponsible relaxation of lending criteria in the US sub-prime mortgage and other markets, the origin of the current financial crisis is to be sought in implications brought about by massive cross-border capital flows and the increasing use of financial instruments/derivatives (the securitization of various obligations) which are not transparent and traded effectively. Financial markets have become, in certain areas, increasingly opaque and, identifying those who bear the risk together with evaluating it represent formidable tasks. The size of the so-called “shadow banking sector”, which is lightly regulated, has been constantly increasing over the last 10-15 years.

This evolution brings to memory the Gurley-Shaw report of decades ago, which highlighted the imprecision in distinguishing between credit and money; and, consequently, major hurdles for effective monetary policy. Banks themselves have been caught in this game by their origination and distribution operations, flawed risk management practices. Not a few leading banks have engaged in highly questionable packaging and selling of debt tied to high risk mortgages. And several Wall Street major banks have come under the scrutiny of prosecutors lately. A Glass-Steagall type recreation of Chinese walls for the sake of restoring trust and transparency would, quite likely, be unworkable nowadays.

But there is an obvious need to regulate financial markets more widely and better. The deepening of the financial turmoil refutes glaringly those who said that the financial industry is capable of self-regulation. How hollow sound, now, the voices of those who, not a long while ago, kept rejecting the need to regulate hedge funds and similar vehicles. That a group of biggest London funds have drawn up a code of conduct for their industry is quite commendable, but I doubt that is enough. It is quite unfortunate that more thorough lessons from the LTCM episode, the dotcom bubble, the Enron and Parmalat affairs, etc. have not been learned by national regulators more thoroughly.

There is, in my view, a need to revise the regulatory frameworks for the operation of investment vehicles. There is also a need to regulate the very use of financial instruments (of CDOs, for instance), so that the transparency of markets be restored and investors be adequately informed. As banks are required to hold minimum reserves a similar rule could apply to other financial institutions. Likewise, the magnitude of leveraging could be capped.

And a final note: better regulation does not mean a reversal of financial liberalization; the opposite is true. Financial liberalization, in order to be sustainable (and not produce irreparable damage), demands proper (enforceable) regulations.

****
January 31st, 2008- EUROPEAN VOICE