Financial Scandals, Regulation and Democracy

Posted on November 13, 2013 by

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Dr Vincenzo Bavoso is a researcher in the Department of Law at Durham University on Work Package 2: Financial Crisis in the Banking Sector of the Tipping Points project. He is looking at the role of law and legal institutions in preventing financial crises and limiting systemic risk in financial markets. In this interview he talks about his research in financial scandals and how regulation can help make financial markets accountable to democratic societies.

In your research what financial scandals did you investigate?

When I examined financial scandals for the purpose of my research I focused on the accounting scandal age from 2001-03, along with Northern Rock and Lehman Brothers in the context of the recent global financial crisis. Financial scandals are caused, among other things, by mismanagement, and lack of understanding of certain processes. All of this is based on certain failures of regulation. You would expect there would be supervision in place and in all of these examples of large organisations with lax or flawed managerial processes, it was not.

Do you think these scandals mainly exist due to a failure of regulation or do you think something within the financial system allows some of these events to occur?

During a period of financial boom, such as the 1980s, the economist Hyman Minskycame up with a theory of financial instability. He thought the larger a financial system develops the more it will be prone to instability then eventually to crisis or a situation of default, which is something we experienced before the explosion of the global financial crisis. After that ‘tipping point’ if you will between 2006 and 2007 it went from boom to bust. The problem is that when you’re in a period of boom nobody seems capable of recognising what the limits of the system are. Nobody seems to be able to see that the system is not resilient or if an individual or institution does raise red flags they are not heeded.

What was the role of scandal during the financial crisis?

The Northern Rock scandal ignited panic, what we were calling at that time ‘credit crunch’, then the bankruptcy of Lehman Brothers, the fact it was allowed to go bankrupt, I think that triggered the systemic effect of the crisis. So two financial scandals effectively can be singled out as milestones of this much broader and deeper crisis that we are still experiencing.

In your work you talk about including social interest in financial regulation. When it comes to financial markets there is a clear line of demarcation between private and public, how do you think financial regulation could account for example the impacts of the financial system on society?

That’s a key development that needs to be taken under consideration both in academia and in practice, because effectively unlike legal fields such as competition law or environmental law where there is a formulated concept of public interest, this proposition doesn’t exist in financial law and therefore it is not translated into laws that are aimed at protecting the general public or its broader societal constituencies. The private interests of market players reign above all other interests and because market players are assumed rational market actors, because they act rationally to maximise their profits, that in itself is a form of regulation. If you could argue that they were acting rationally because they were pursuing their role in profit-making, that doesn’t really translate into wealth for other constituencies.

Do you think you can include social or public interests within these privatised systems through regulation?

The way finance is regulated doesn’t contemplate the type of framework whereby public interest is factored into regulation. You would need to nationalise the regulation of financial markets. You would need to re-define the way in which financial regulation is conceived. How would you do that? Firstly through a different type of regulator, a different institutional framework of financial regulation, making it more democratic and accountable to the public.

Are there any examples we can point to from the past or present where we could understand this globally?

I think a good idea of financial revolution that occurred after a crisis was the New Deal in the United States, a form of democratic legislation that was aimed at fixing the financial system after the 1929 stock market crash.  You have the first financial regulator in history that was created with the Security Exchange Commission and a set of regularity tools that really functioned very well, up and till the deregulatory age started by Reagan that culminated with the Clinton government.

Achieving a sustainable, resilient and efficient global financial system is extremely difficult. The financial system has become global after the age of liberalisation, however, sovereign states remain independent from each other. Reaching a global consensus which goes beyond the EU or the G20 for instance on how finance should be regulated or what role finance should have in society I think at the moment is unfeasible. I think a global regulation of the financial system is possible only if you compromise on that and you accept that it’s going to be undemocratic, so something underpinning or stemming from the initiatives of undemocratic, semi-private fora like the Basel Committee, the Financial Stability Board or the G20, which are not representative of all the constituencies at stake.

In your book you propose ‘enlightened sovereign control’ as an alternative, in the specific area of corporate law, to the dominant shareholder value model. While the shareholder value model is primarily concerned with delivering value to shareholders, enlightened sovereign control considers non-economic social issues. How is this useful to financial regulation?

What I said about the revolution that occurred after 1929 is something I think should have happened or should still happen as a consequence of the global financial crisis. Two main things that should be addressed are firstly reassessing what the role of finance in today’s society should be? That is something that needs to be clarified, because finance has been let free to grow uncontrolled essentially. And the second thing is to regulate something that has become so complex, so intertwined and interdisciplinary as well. You need a new breed of competencies, you need a new profession. One of the things I observe in the context of my proposal is that this profession that could address this financial revolution does not exist at the moment.

Enlightened sovereignty addresses this problem by helping to establish a new profession that would have to be a permanent forum of professionals that is state-based. By ‘state-based’ I mean a professional body that is independent of both the market and government. I think often when people hear the word state they tend to associate it with government. The problem is government is as biased as the market is. Achieving independence would be a third way, neither government nor the market. I think a professional body, backed by an act of Parliament and accountable through public law mechanisms would be key.

Do you think close financial monitoring is a way to mitigate or prevent future financial crises?

Definitely. Obviously if you have good monitoring you have a prevention mechanism essentially, which is better than enforcement after the event. The key question is not whether to supervise or not, but who you want to supervise because the financial system has developed in a way that has allowed private entities to retain regulatory and supervisory powers. The most astonishing example of this is credit rating agencies, gate-keepers stamping the viability of debt transactions. Gate-keepers are in theory operating in the public interest, but in practice do it for private interests. Beyond that you have the FSA in the UK. The FSA was in fact conceived as a market based regulator even though it was created through an act of parliament. But the intrinsic characteristic of the FSA was it being a market friendly regulator with principles-based regulation and with sort of laissez-faire approach to supervision of the market players. You could point to the failure of Northern Rock as an example of how adequate surveillance was lacking. Why didn’t anybody give warning signs? The supervisor didn’t raise questions. That is an example of why monitoring and supervision are fundamental tools in this broader picture.

From a legal perspective what were the major causes of the financial crisis?

Obviously there is a failure to regulate, a failure to supervise the system and the institutions therein. There are macroeconomic causes of course which are at the root of the problem. But from a legal perspective, failure to regulate issues such as the level of debt that institutions are allowed to take; failure not only to regulate but to understand the process of financial innovation, because at the end of the day if institutions were allowed to reach ridiculously high levels of leverage, to become so interconnected, then the problem should have been to look at how they were achieving their profitability in the short-term. The answer is in the transactional innovation that has happened over the last two decades. There is virtually no regulation of such financial transactions (like Collateralized Debt Obligation (CDO)) for instance. Partly because some of them are the offspring of innovation and partly because of the deregulatory process, so for instance speculative  Over-The-Counter (OTC) derivatives were liberalised in 2000 with the Commodities Futures Modernization Act by the Clinton administration in the US.

What role do you think emerging economies have in all of this?

What emerging economies have in common is that their economies are not as heavily reliant on financial systems as their main leverage, unlike more developed Anglo-American type economies. Now this is partially because some of these countries have natural resources, like Russia most prominently or South Africa. I think their “real” economy is still prevailing over the financial system. So they will eventually develop sophisticated financial markets but the way in which that will happen is not necessarily the way we in the West understand financial markets, which have been left free to grow and regulate themselves. We in the West tend to think the way we do things is the only way. Whereas emerging economies will probably show us there are different ways of doing things. There are different economic patterns that can be followed.

Vincenzo’s book Explaining Financial Scandals: Corporate Governance, Structured Finance and the Enlightened Sovereign Control Paradigm is available online and the introduction is available for free.

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