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FINANCIAL LAW ANDFINANCIAL LAW ANDREGULATIONSREGULATIONS
WEEK 2
Recent Trends and Problems of the
Global Financial Regulations
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Further to last week, we are going to look
into: Specific problems with financial assets
Regulations in response to bank failures inrecent decades
Types of regulatory framework
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George Soros (finance guru): financial markets arealways biased ?
Distorted views of market participants can affect thefundamentals of market ?
Equilibrium the ability of markets to find their own price
levels cannot be taken for granted
Regulation is based on the outdated concept that marketscan regulate themselves ?
Do we really understand how does
the Financial Market works?
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Financial Markets
Traditionally greater emphasis was placed on themarket forreal assets such as factories, land andother means of production
The role of financial markets was seen tosupport the market for real assets which wouldalways find their own equilibrium
Therefore, developments in financial marketsshould only be a reflection of what washappening in the market for real assets
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REAL ASSETS-house, factories,
- land, etc
FINANCIAL ASSETS- stocks, bonds, etc
Financial Market
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Financial Markets
But the health of financial markets determines confidence which drivesconsumption, savings and investment economic development
Contemporary financial markets can be very profitable for majorintermediaries
Greater risk taking may significantly increase profits but can alsocause financial failure
Failure can lead to a market crisis and a loss of liquidity that canquickly spread though out the world
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Effectiveness of regulations
Much regulation has developed in response to aseries of market failures.
Regulation does not cover all areas of risk suchas derivatives
Regulation is often based on the belief thatmarkets know best hands off
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Theories of Regulation (contd)
The Theory of a Market for Regulations Wealthy people want regulations to support their
own private interests
Regulators are sympathetic to the regulated The Dynamic Theory Dynamic interaction between consumers,
regulators, and the regulated, until a equilibrium
between consumers and the regulated firmsRegulatory Dialectic Constant evolutions
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Theories of Regulation
The Theory of the Public interest Inefficient market practices may result from
monopolies, and other external conditions
Government should create regulations to protectpublic interests
The Capture Theory Government regulations are not necessarily in the
public interest Only bankers know how to regulate a bank? The regulated end up regulating themselve.
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Looking back
1929 US Wall Steet Crash. Between 1929 and1931 employment reduces by a third
US Congress passes the Securities Act in 1933requiring registration of interstate offers for sale ofsecurities
US Congress passes the Securities Exchange Act in
1934 to govern secondary trading of securities
Regulation curbed abuses which led to the crash
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Bank failure in Europe
In 1931 the Credit Anstalt Bank in Austria failedMuch of Europe including Germany and Englandwas badly affected
The Bank of England organised a rescuepackage
But the concept of international regulation is far
from being established
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More bank failures in 1970s
Differences in economic performance force the end offixed (pegged) rates in 1971 and major currencies areallowed to float (market determines rates)
In 1974 three banks fail due to poor management andlarge currency losses:
Herrstatt Bankhaus in Germany British Israeli Bank in London, and
one of its creditors: Franklin National Bank - USA
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Criminal intent
The Franklin National Bank (Franklin Bank) was previouslybought by Michele Sindona (the Shark)
Close ties to the Mafia (Gambino family) and Banco
Ambrosiano and its main shareholder (Vatican Bank)
He used the Franklin Bank to expand his criminal activities inthe USA drug trafficking money laundering
He apparently had ties to the US Republican Party and theNixon administration
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Criminal intent
Sindona was later extradited to Italy where he wassentenced to serve time in prison
In prison he later he died of Cyanide poisoning whilst
drinking a cup of coffee (murdered ?)
In 1982 Roberto Calvi (chairman Banco Ambrosiano)was found dead hanging from Blackfriars Bridge inLondon with a stone in his mouth
The Franklin Banks assets were acquired first byEuropean American Group and later by Citibank
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Early 1970s characterised by serious disruptions incurrency and banking bank failures
G10 Central Bank governors establish the Basel
Committee on Supervision
Herrstatt (a German bank) failure showed that regulatorresponsibility was not clear and threatened USsettlement system
Which supervisor (in what country) if any wasresponsible for the foreign operations of a bank ?
Responsive regulations
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Latin America financial crisis During the 1970s countries such a Brazil, Argentina
and Mexico borrowed heavily from major foreignbanks to finance industrialization
International banks made good profits
Between 1975 and 1983 external debt increasedfrom US$ 75 B to US$ 315 B much short term.
Annual interest and principal repayments increasedfrom US$ 12 B to US$ 66 B
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Latin America financial crisis
Oil crisis (prices quadrupled) caused recession during1970s and 1980s and borrowers faced liquidity problems
But US$ deposits made by oil exporting countries were later lentto Latin American borrowers (governments). Money wasrecycled!
1982 Mexican Finance Minister announced that Mexico
could not meet repayment schedule.
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Latin America financial crisis
Lenders lost confidence and refused to extend furthercredit loans were called in
But too late capital flight out of the region
Major banks such as Chase Manhattan and Citibankwere badly exposed could have failed
IMF provided emergency loans and assistance up tothe end ofthe 1980s. Loans were used to repay banks.
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Responding regulations
Focus during the 1980s was on capital adequacy 8%
1988 Base lI but regulators could not commit theirnational parliaments to agree and enact intodomestic / national law
Parties could only commit to do their best
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Basel II
Why were lending mistakes still being made ? Basel accord needed to berevisited
In 1996 the updated Basel II clarified the primary responsibility of homecountry supervision rather than host country
EU countries enact into domestic law to provide locally headquarteredbanks with an EU passport
EU requires incorporation into domestic law but not the USA, Canada andJapan
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Lesson: Moral hazard
Why did the banks lend so much money when itshould have been reasonably clear that the borrowerswould default ?
Were the banks learning to take on excessive risk thatcould eventually be passed on to the tax payers ?
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More troubles with thefinancial markets
1980s, 1990s and
2000s
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Financial engineering 1980s
Availability of cheap computing power powered thegrowth of international currency trading throughinternational banking system
Markets forderivatives grew but these remained largelyunregulated
But derivatives can be used to both minimise and to
create risk
*Intl Swap and Derivatives Association
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Failure of BICC in 1990s
1991 Bank of International Credit andCommerce (BICC) fails due to criminal activitiesof its founders and senior management
Depositors worldwide including Hong Kong losetheir savings
Bank headquartered in London but owned by aholding company in Luxemburg
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Failure of BICC in 1990s
Liquidator sued Bank of England for negligence lack of supervision
Bank of England claimed that Luxemburg wasresponsible as the ultimate parent wasdomiciled there
Bank of England claimed that a heavy handedapproach would damage the London financialmarkets
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Mexican crisis in 1994
1994 Mexican financial crisis triggered by the sharpdevaluation of the Mexican Peso
Heavy government borrowing using Tesobonos (denominatedin Pesos but indexed to the US$ using a currency peg)
Political instability, poor banking systems, bad lending,corruption
Central Bank depleted US$ reserves forced to let Peso float
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Mexican crisis in 1994
Refinancing (rolling over debt) becameimpossible
Capital flight puts further pressure on Peso
US under President Clinton along with IMF, BIS
and others organised a US$ 50 B bail out
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Asian financial crisis in 1997
Asian financial crisis in 1997 was fuelled by banks inmostly Thailand and Indonesia borrowing US$ at lowinterest rates and re-lending in local currency at highrates.
Lending created speculative bubble and opportunities forcorruption
Borrowers defaulted and banks became insolvent The Thai Baht collapsed and the currency peg to the US$ was
severed
The IMF provided a US$ 40 B support programme
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Russian financial crisis in 1998
In response to the Asian crisis global demand andprices for commodities such as oil and metal ores fell
Compounded by declining productivity, an overvaluedexchange rate and a chronic fiscal deficit
In 1998 Russia announced that it could not meet its
obligations on its sovereign bonds - default
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Russian financial crisis in 1998
IMF and World Bank provided a US$ 26 B aidpackage
Investors worldwide started to repatriate shortterm investments from developing countriesworldwide
Classic example of the Domino effect - Asian
and Russian crises in turn affect Latin America
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New developments privateequity and funds
New forms of investment vehicles become popular in the1990s:
Private equity using mostly pension funds to make short term
leveraged investments in private companies. Banks supplylending. Typically unregulated
Hedge funds which use funds (private and bank loans) tomake even shorter term speculative investments in foreign
currencies and shares. Typically unregulated
Securitisation typically selling corporate bonds tofinance home loans
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Another collapse
The Long Term Capital Management group (LTCM) hedgefund collapsed towards the end of 1990s. Foundersrepresented the elite of financial minds in the US
They claimed to have developed a zero risk model ?
But they lost US$ 1.25 B of investors money on a wrong bet arbitrage (after the Russian economic crisis)
The New York Federal Reserve Bank organised a rescuethrough a group of investment banks who were its primarycreditors
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Deregulation..
In 1999 the US Congress passed the Gramm Leach Bliley Act
Allowed banks to offer a variety of savings,investments and insurance products under one roof For example, Citibank merged with Travelers Group
Reversed 1930s legislation which had separated
commercial and investment banking
Swept away regulatory safeguards and oversights
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Enrons failure in 2001
In 2001 the Enron corporation failed
Fortune magazine had named it the most
innovative company for six consecutive years
Credit rating agencies had rated it highly
Heavy debt and overstated profits wereconcealed by carefully planned accounting fraud
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Enrons failure in 2001
Arthur Andersen (companys auditors) were forcedto cease business when it was alleged that theywere partly responsible and when their employeeswere discovered to be destroying evidence
CFO later cooperated with the investigators
US Congress passed the Sarbanes Oxley Act in
2002 to address shortcomings revealed in thescandal
Credit rating agencies claimed they were misled
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Argentinean debt crisis in2001 Crisis in 2001 caused by several factors:
High unemployment
Weakened economy
Overvalued exchange rate
Caused run on banks deposit withdrawals restricted
Could international regulation have helped ?
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The Internet Boom
1999 - Merrill Lynch operated an Internetgroupwithin its investment banking division
Analysts were required / pressured to writepositive reports on companies going public Buy recommendations
At the same time they were sending emails toeach other describing shares in those samecompanies as a piece of crap
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The Internet Boom
New York Attorney General Eliot Spitzer filed an affidavitwith the court
2002 Merrill Lynch declined to go to trial and instead paid asum of US$100 M without any mission of guilt to end theinvestigation.
2003 SEC and New York Attorney General and others agreedout of court settlement of US$ 1.4 B with 10 financial firms
Included US$ 80 M paid by Lehman Brothers
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Financial Tsunami
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New fast money-making idea withthe mortgage financing business
During early 2000s, originators made money throughcommissions earned from creating the mortgages butpassed the liability itself on to others
Mortgage originators had securitised the loans and sold themthroughout the world
Banks throughout the world bought these bonds and lost
significant amounts of money bad luck ?
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A series of failures in the U.S.banking sector in 2008
Bear Stearns failed acquired by JP Morgan Chase Employees were partly paid in company shares which
became worthless
Merrill Lynch failed taken over by Bank of America Lehman Brothers failed partly acquired by
Nomura
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Toxic assets
Sub-prime mortgage started to unfold in 2007
US banks had lent trillions of dollars to finance US
home purchases
But borrowers could not repay and defaulted
As property prices fell, lenders could not recover loanvalues
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Mini bonds in Asia Credit linked derivatives direct default risk to the investor
Apparently guaranteed by Lehmann Brothers but thebank failed
Name misleading ? Claims of misrepresentation ?
Investor protection - sold to unsophisticated retailinvestors why ?
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Second Tsunami ?
Similar amounts of mortgages were sold with aprovision to maintain low interest rates for the firstthree years
They are now starting to reset to higher (normal)rates
Defaults are expected to increase significantly second wave of toxic assets over the coming two tothree years