——— FINANCIAL POLICY FORUM ———
DERIVATIVES STUDY CENTER
1660 L Street, NW, Suite 1200
Washington, D.C. 20036
Standards And Codes: Can They Prevent Financial Crises?
Thursday, May 27, 2004
International Monetary Fund
Schneider, United Nations Conference on Trade and Development
Randall Dodd, Derivatives Study Center and the Financial Policy Forum
Aziz Ali Mohammed, Honorary Advisor to the Chair, G-24
Jesus Seade (Moderator), International Monetary Fund
Transcript of remarks by Randall Dodd (edited to improve readability)
I had sort of a different line of presentation that I wanted to add because the other participants know so much better than I about some of the problems and the process of the Standards and Codes agenda. I just wanted to present a few other economic points that I hope will add some value to the discussion.
One is just to identify three or four areas I think where the standards and codes project represents a very daunting task. The most obvious to those discussed in Benu's book are, of course, the scope and scale of the enterprise. Not only is it something that's global in scale, but also in terms of scope. Even with only 12 codes, that's still actually quite a bit of terrain to cover if one wants to focus on the concrete, detailed policy rules or guidelines that one wants to discuss.
And as daunting as a task that is, I do think there is some upside benefit from a developing country point of view. One of the things I've been very concerned about is the way in which some of the major players in the financial markets, New York-London financial institutions for example, sometimes play a very pernicious role in developing countries.
I've sat down and talked with members of the IMF staff and talked about this, about some of the problems that have come to light in the wake of the East Asian Financial Crisis. And one senior member of the IMF’s PDR group said to me, "I haven't see one financial sin committed in East Asia that didn't have as its counterparty a bank in New York or London." So I think there are some reasons there for why some guidelines and rules that are consistent across borders might actually play a salutary role.
Another daunting task, and one that Benu and Aziz Ali have talked about very well, is some of the difficulty in the process of creating and establishing Standards and Codes. It is toward this final one where I want to try to contribute by offering some sense of both intellectual and economic policy coherence. When I read through the literature and read through some of the debates, there's a certain tendency toward ad hoc approach. I think it's due, in part, as I mentioned earlier to the daunting scope of the enterprise. The Standards and Codes discussion includes about everything from sovereign bankruptcy procedures to the regulation of securities markets, anti-money laundering provisions and how to tie all of this together. It is a very difficult task, I grant, but there are some reasons to tie it all together. One, you want to be consistent both across policies and across countries as they're going from developed to developing countries.
Another reason is that in terms of the process, the more coherent it is, the better off we are. I think a lot of us here come from academic economics backgrounds. And I know from my own background, from the PhD program I went through, that finance is not something that I was really taught. We didn't really study financial economics as a field or as an identified subject matter in most Ph.D. programs. So what we did learn as economists was to study markets -- usually financial markets were not viewed as different from any other -- and then to identify how, invariably, government regulation messes things up. As a result, people can go through their whole career explaining how government policy is always an inferior outcome, a non-Pareto optimal situation, and that the evaluation of policies is an evaluation of which ones mess it up more or less. The ones that mess it up less are the better ones, or this tax is better than that one because it is less distortionary.
I think in this endeavor, though, we need to have a better foundation than that. And I think what we need to think about is creating an intellectual framework in which we can identify where markets either fail, where they're imperfect, where they're incomplete, and then ask whether government regulations can, in fact, make the markets better than pure market outcomes, where the government involvement in setting standards and codes, rules or guidelines, if you will, can actually improve market efficiency as well as stability. This approach can potentially really add some value to the debate, can make the results more coherent and make it more of something that people want to embrace.
At this time, however, I just do not see that development in the literature, and I apologize if I’ve overlooked it. I have made some attempts on my own to develop it, but due to disorganization, lack of discipline and absence of talent I have not finished it. But I hope to throw it up on my website soon – it is www.financialpolicy.org.
Let me tell you a little bit of where I think this would go and where this might help. For example, there's a lot of debate over capital requirements, whether Basel II is appropriate or not and whether it is better than Basel I. No one has really come up, as I've seen, with a very good explanation of why we care about capital requirements quite so much. Are these really the principal source for banking sector stability, and market determined levels of capital inadeqate? Unfortunately we have not really established these points.
John Eatwell has argued that capital requirements are really not such a great source of a safety cushion because they really do not function as a buffer. They may function, though, as a governing device to limit risk. Restrictions on the range and concentration of investments of banks’ assets is another example of governing risk taking. That governing function alone has a virtue even if it is not, per se, a buffer.
There are other regulatory measures that might, in fact, be better buffers. Banks’ deposit requirements service as liquidity buffers. Collateral and margin requirements for leveraged asset purchases, short-selling, repurchase agreements and derivatives transactions are other effective buffers.
There are other measures that might do a better job of ensuring stability than capital requirements. That debate though doesn't seem to be occurring. Instead, we are locked into some very technical and sometimes tedious debates about whether internal risk assessment models are appropriate compared to more rigid ones than we had in Basel I, and while that is a good debate, it is hardly exhaustive and it hardly fully addresses the issue.
Let me suggest, in a few minutes, another way of beginning to think about this. Due to laziness and lack of talent, I have not got it polished yet, but I really hope to make it available soon.
The first thing I want to think about is identifying some market problems such as the externality of risk. One of the problems that I think underlies financial markets is the social cost of the failure of an institution or a transaction or the broader financial system is often greater than the cost of individuals that are investing. In other words, there is an externality of risk. If I do something, and it blows up in my face, the social costs exceed my cost. What does that mean? Markets don't fully discipline my risk-taking activity.
So, if you can argue that the private costs are less than the social costs, then the private instruments are not going to sufficiently regulate the market, and therefore you need to do what? Come up with a better scheme to try to limit, mitigate and deal with risk protection. One way of doing that, of course, is capital requirements not just for banks, but for broker-dealers, other financial intermediaries, perhaps even people engaging in insurance and derivatives transactions.
But why just look at the institution as a capital requirement? Why don't we really look at the transactions? Why don't we focus as much on the way in which we collateralize loans as much as the bank holds as capital against the risks embedded in the loans on the asset side of their balance sheets? Why do we establish collateral requirements for securities transactions but not also derivatives transactions?
And so these may be a much better way of governing, if you will, risk-taking activity. We have sort of fallen into, as the economics profession, the habit of focusing on a couple of little technical debates about Basel II. I think capital and collateral requirements are lessons that you can see embedded in the history of, for example, U.S. banking regulation and financial market regulation. Despite the fact that the U.S. has had two economic downturns in the last 14 years, at neither one of them did the U.S. have a substantial failure of a financial institution. Enron failed, WorldCom failed, but financial institutions did not fail.
The other thing to think about, as well as externality of risk, is information. There has been a lot of work on asymmetry of information, and that's important. I think that is an important way in which to motivate a discussion on transparency. What is also important to markets, maybe more important than symmetry, is the cost of information. How can all of the market participants be fully informed if the information is costly or just completely unavailable?
And if you look at the history of this country – the U.S. – and its financial market regulation, it's been driven very much by disclosure requirements, registration requirements, and reporting requirements. The data and other market information does not come from nowhere. Firms tend to hoard information because they have incentives to do so. They must be required to disclose information so all of the market is better informed and so there is no trading on non-public (i.e. insider) information, and as a result the whole market is better off and more efficient.
So here we see the hoarding of information as sort of a market failure that won't get us to the Pareto-optimal situation. We need uniform disclosure requirements so that no one firm or individual is disadvantaged by their disclosing information because the requirement will disadvantage everyone equally and enable to the market to move to a new higher level of market efficiency. This would be true for the symmetry issues as well as the cost issues.
Sometimes the government just needs to absorb the cost of collecting and disseminating information. It is, by and large, not terribly expensive in comparison to its potential effects on the market.
In that context, the debate over transparency then can be informed by what sort of information is really proprietary versus what is really needed for the market in order to create more efficient price discovery process.
Also is this context, we need prohibitions against fraud and manipulation. These are things I haven't heard come up in the context of standards and code discussion, but they are absolutely critical for maintaining the integrity of markets and market prices. What good are stable market if participation is diminished because of rampant fraud and manipulation. And so we need to have not only reporting, and registration, and disclosure requirements, but we need to have strict prohibitions against fraud and manipulation, otherwise the prices can send off false signals, and this is a big problem.
In the U.S., for example, where it is otherwise well regulated, there are have huge, gaping holes in the regulatory framework which has led to problems with energy price manipulation, amongst other items, through the use of over-the-counter derivatives. In there markets there are not strict prohibitions against fraud and manipulation.
The next thing besides risk and information I want to mention is that some areas of financial markets are natural monopolies. Liquidity tends to gravitate to liquidity. As a result, you generally find that one exchange, one marketplace, emerges amongst them all. It is because of the effective information and the advantages of liquidity that there are natural monopolies being formed.
When this occurs the government needs to play a role to make sure that the rules governing that monopoly exchange or market are suitable for the overall economy. And we see the way that's done, for example, again, in the U.S. with our futures exchanges and stock exchanges and how there are regulations governing their disclosure of information and the integrity of the participants.
Let me wrap up by saying that this is just a beginning of a way to think about how we can build our standards and codes on a more coherent economic foundation, and thereby generate more consistent policies. I think this will also help protect the interests of developing countries from being, if you will, victimized by being the passive recipients of policies designed for other people's self-interests.
Based on my experience working for years in the U.S. to try to shape financial market regulation, I find that far too often there is an absence of a good, honest intellectual discussion on the matter of financial market regulation. Too often is merely a squabble between competing vested interested. The result becomes just the victor of the conflict between private interests, between large-cap firms and high-tech firms, between Wall Street firms and Main Street firms, between, in this case, Wall Street, U.K. firms and developing country financial institutions.
What we need is an economic analysis that identifies the public interest in the sound and efficient working of financial markets. What you need is to come up with a better intellectual foundation.