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(NEWZIMBABWE) The era of de-regulation in financial services is over

The era of de-regulation in financial services is over
By Victor Chimbwanda
Posted to the web: 15/10/2008 14:20:32

SINCE the East Asia Financial Crisis of 1997, financial regulators across the world have been adopting global standards in an attempt to detect, prevent and contain national, regional and global financial crises. These standards have been increasingly incorporated into domestic laws by respective governments in order to address weaknesses that exist in financial systems.

While the development of these standards presented a case for legal reform in emerging economies, the current global credit crisis has exposed the inadequacies of the regulatory frameworks used to monitor global financial markets to prevent liquidity crises. Hence, it is no longer emerging economies that are vulnerable but the entire global financial system.

This has put the entire global economy at risk. It has become necessary, therefore, for current regulatory frameworks to be revamped in order to close the loopholes that gave room to rogue traders and unscrupulous bankers in Wall Street that created the current liquidity crisis.

Banks over the years have been involved in risky off-balance sheet activities that are beyond regulatory control. Through a process called securitisation, they would off-load part of these risky business activities to special investment vehicles (SIVs) that would trade on the international financial markets with little or no regulation at all. This business strategy known in financial jargon as the “originate and distribute model” is less risky for the banks but has the capacity to bring huge profits.

It has always been the unwritten rule that banks and institutions that engage in such activities should not expect liquidity support of the central banks in times of crisis because of what is referred to as “moral hazard”.

What triggered the credit crisis was that risks associated with such activities which were supposed to be borne by investors found their way back onto the balance sheets of banks that “originated” them when the financial markets ran into a liquidity problem as a result of the 2007 US mortgage crisis.

These off-balance sheet activities created very complex financial instruments (securities) that could be traded in financial markets across the globe. So complex were they that they failed to absorb all the risk as had been contemplated.

What this meant was that when there’s a crisis in the financial markets, banks had no option but to support these SIVs. This inevitably put banks under tremendous strain. They needed adequate financial resources to sustain this sudden need for liquidity. But because banks borrow short and lend long, short-term assets are transformed into long ones which means that when there’s a shortfall to cover immediate liquidity needs, banks have to borrow from each other.

Because all major banks were experiencing the exact same challenges owing to the risky securitised transactions, they became unwilling to lend to each other because they needed to hold on to their resources and avoid compounding their own liquidity problems.

Under normal circumstances, banks would be able to raise money from the financial markets but they have been failing to do so because investors withdrew their money since they were not willing to be exposed to the “toxic” US mortgage securities that lost value on the financial markets when it was discovered that some mortgage lenders had given mortgages to borrowers who had no means to repay such loans. These are the so-called “subprime mortgages”.

The argument therefore is whether the institutions confronted with such liquidity problems should be guaranteed liquidity support by central banks when it’s clear that they took on too much risk? Sounds familiar?

This is precisely what the Reserve Bank of Zimbabwe had to deal with during the banking crisis of 2003-4 when several banks that had engaged in risky practices bordering on illegality were no longer able to fund their operations. [Please refer to my article of 10/10/2008]. As we reflect on this issue in light of the on-going global liquidity crisis, there is need to address the question, how best can such crises be avoided?

Writing for the International Law Journal, a renowned expert and academic, Prof. J. Norton (1999) observed that financial crises in recent times reflect deficiencies in the legal frameworks that support various economic, financial and commercial systems.

Addressing problems in the financial sector in particular, such as corruption and irregularities in the liberalisation process, he argues that all these weaknesses are a result of law-based failures and that there is a need for “meaningful bottom-up economic, financial and commercial law reform throughout emerging and transition economies”. As I have noted above, this is no longer a problem unique to emerging economies because the ongoing financial crisis started in the US.

What is important is that Prof. Norton goes on to acknowledge the role of legal education as a part of this reforming process.

There is need, therefore, for effective and relevant training programmes to be developed that will target central bank employees, bankers, lawyers, accountants, auditors and even parliamentarians who will be instrumental in contributing to this much needed reform.

The significant developments in the financial services sector as well as in corporate and commercial law are being influenced by a growing literature of global principles and standards promulgated by various international institutions and committees such as the Basle Committee on Banking Supervision. Many of these committees have representatives on the Financial Stability Forum (FSF) that was established by G7 Ministers and Governors in 1999 after the East Asia Financial Crisis.

The FSF was mandated to “strengthen the surveillance and supervision of the international financial system…. to assess issues and vulnerabilities affecting the global financial system and to identify and oversee actions needed to address the problems identified”.

All the weaknesses in our banking system such as financial mismanagement, inadequate or lack of disclosure, structural deficiencies (under-capitalisation), corruption (misappropriation of depositor funds) which the RBZ has had to deal with in 2004, form the thrust of the work of the Basle Committee whose recommended standards have been ignored by many regulators across the world.

It must be mentioned that all these issues, particularly corruption, were at the heart of the East Asian Financial Crisis in 1997, which attracted the intervention of the IMF in order to contain what would have become a global crisis.

According to the 2008 Growth Report, “corruption must be fought vigorously and visibly. Government leaders send powerful signals about values and the limits of acceptable behaviour when they decide on how to respond to cases of misbehaviour”.

In the same context, the then Managing Director of The IMF in1998 called for the modernisation of the legal and regulatory environment. In this respect, it is also worth repeating the famous quote by the Governor of the Reserve Bank of Zimbabwe; “We call upon our legislators to come up with stringent statutes that punitively fight corruption and all its shadows.”

Recently, the group of 30 central bankers and regulators led by Paul Volcker, former Federal Reserve chairman, also admitted that there is need for considerable regulatory reform in many countries.So, while the current financial crisis is being addressed, relevant authorities must adopt a law-based approach to eliminate problems that are inherent in the financial sector.

The era of de-regulation and liberalisation of the financial services sector is certainly over.

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The writer is currently conducting research for his PhD thesis on Central Banking and Banking Regulation. He can be contacted on e-mail: c_victor@lycos.com

Labels: DEREGULATION, FINANCIAL CRISIS

posted by MrK @ 4:09 AM