Preventing Financial Crises

Alexandra G. Balmer on the cat-and-mouse game between regulator and the financial markets.

Recently, a group of students engaged me in a fascinating debate, surrounding human behaviour, derivatives, and the role of the regulator with respect to financial crises. Their curious minds demanded answers as to why regulators do not effectively prevent a financial crisis from happening, given that there are certain market patterns, which are overtly obvious in hindsight. Using the last financial crisis and OTC derivatives as an illustrative example, we agreed that the trigger was not a singular occurrence, but much rather a combination of many factors, including the following:

It is considered human nature to strive to maximise one’s success – particularly financial returns. To achieve this, each market participant seeks out the path considered to provide the greatest gains, while minimising costs. As continuous success stories are the result from a specific type of investment, the market rushes in ruthlessly, aiming to grab its own share of the envisaged fruits. Ultimately, such action often results in a crisis – be it the Tulip Mania of 1637, the stock market crash of 1929, or the subprime mortgage-crisis of 2007/2008. Given that such market movements are known, the question following the crisis is: Why has this not been prevented through prudential market regulation?

In the past 100 years, the nation-state is tasked with protecting the financial integrity of its people. Particularly the regulation of financial markets is a vividly debated topic.

• How much can the market be expected to regulate itself?
• How much personal responsibility can the market participant (or should we call him “player”?) be expected to share?
• How rational is the individual?

Throughout the profitable – and frequently highly speculative – years of the market, calls for liberalisation and deregulation typically outweigh calls for stricter regulation, as each hopes to make his fortune. However, once the losses outweigh the gains on a substantial scale, the regulator is often animadverted for his passive behaviour and lack of market interference. Thus, the political tug-of-war between market liberalisation and growth, popular opinions, and human nature interferes with the rationality of preventing a potential future financial crisis. Both argumentative standpoints have strong validity in their arguments.

OTC derivatives serve as a particularly illustrative example. Derivatives have been used since the times of Aristotle both to hedge and to speculate, as every hedge includes a speculative element. Yet, they never managed to spark a financial crisis, until 2007. What changed? One could argue an overall low interest market condition spiked people’s appetites to seek higher returns in riskier investments, which they found in inexpensive mortgages to purchase real estate. At the same time, mortgage-givers divested themselves of the subprime credit risk, by entering into transnational derivative contracts with other banks, insurance-firms, and investors. Globalisation of the financial derivatives market, particularly the widespread use of ISDA Master Agreements, enabled the proliferation of risk across traditional national barriers, which had prevented similar usages of OTC derivatives in the past, as contractual enforcement could not be guaranteed. This market self-regulation was highly appreciated and heralded as a success story, while the underlying and inherent risk was neither sufficiently documented nor understood. This resulted in costly taxpayer funded bail-outs in an attempt to halt the unravelling of the global financial markets. Once again, the regulator was animadverted and had to justify his lack of actions.

It is always easy to detect risk in hindsight, but considering the political and market reaction, had the regulator proposed to (re-)regulate OTC derivatives, amidst the flourishing market environment in the early 2000s? While certain voices demanded just that, the political pressure to refrain therefrom strongly outweighed any such voices. It is quicker to teach a child that the stove is dangerously hot, after it has been burned by it; and we have chosen the same approach with financial market regulation. Perhaps we should reconsider how we view financial regulation. Instead of believing that it halts financial (product) innovation and profitability, we should embrace it and find new solutions to make our financial system more stable.

However, such is not human nature and markets always seek out the unregulated niches, where small investments allow for large profits, until – all over again – the losses outweigh the gains and the regulator intervenes. As such, the cat-and-mouse game between regulator and market continues, where political and popular demands for hindsight-regulation and foresight for next time are just as short lived as the streak of luck for most non-professional investors during the latest boom.

Alexandra G. Balmer, PwC Switzerland AG

Regulating Financial Derivatives is available now.
Read chapter one on Elgaronline