- The UK Treasury’s package aimed to ensure the stability of the financial system and to protect ordinary savers, depositors, businesses and borrowers. Apart from providing sufficient liquidity in the short term through the Bank of England’s Special Liquidity Scheme, the government provided a guarantee of short- and medium-term bank debt in order to ensure that the banking system had the funds necessary to maintain lending in the medium term. It also forced banks drawing from the rescue scheme to recapitalize, reinforcing their capital base. The Treasury undertook to underwrite the share capital increases of participating institutions and take equity stakes in the banks concerned by means of preference shares. See “The Treasury’s Statement on a Bailout for British Banks to Rescue the Financial Sector from the Turmoil of Recent Days”, The Telegraph, 8 October 2008, available at http://www.telegraph.co.uk/finance/financetopics/financialcrisis/3156569/Banking-bailout-The-statement-in-full.html (last accessed 10 November 2008).
- For a detailed account of the global financial crisis during September and October 2008 and a description of the rescue packages, see Bank of England, “Financial Stability Report” (October 2008, issue 24).
- “Deleveraging, in this context, covers a range of strategies. On the liabilities side of bank balance sheets, these strategies entail raising fresh capital, as well as ensuring diversified, longer-maturity, and durable sources of funding. On the assets side, the strategies are to avoid concentrated exposures to illiquid or risky assets, dispose of noncore assets, and adopt hedging strategies that accurately mirror exposures.” IMF Global Financial Stability Report, “Financial Stress and Deleveraging, Macrofinancial Implications and Policy” (October 2008), 19. For the role of deleveraging in the second phase of the global crisis see idem, 19–31.
- House of Commons, Treasury Committee, Fifth Report of Session 2007–08, “The Run on the Rock”, 24 January 2008.
- A Seager and P Inman, “US Steps in to Rescue Failing Home Loan Giants”, The Guardian, 8 September 2008, available at http://www.guardian.co.uk/business/2008/sep/08/freddiemacandfanniemae.useconomy (accessed 18 November 2008).
- Robert Winnett, “Effort to Halt Financial Crisis Costs Governments Two Trillion Pounds”, The Telegraph, 15 October 2008, available at http://www.telegraph.co.uk/news/3198470/Effort-to-halt-financial-crisis-costs-governments-two-trillion-pounds.html (accessed 24 November 2008); IMF Global Financial Stability Report, “Containing Systemic Risks and Restoring Financial Soundness” (April 2008).
- The Bank of England, “Special Liquidity Scheme: Market Notice”, 21 April 2008.
- This consensus was first perceptively described in JJ Norton, CJ Cheng and I Fletcher, International Banking Regulation and Supervision: Change and Transformation in the 1990s (The Hague, Kluwer Law International, 1994) and JJ Norton, Devising International Bank Supervisory Standards (The Hague, Martinus-Nijhoff, 1995).
- Basle Committee on Banking Supervision, “Core Principles for Effective Banking Supervision” (September 1997, revised in October 2006) and “International Convergence of Capital Measurement and Capital Standards, A Revised Framework” (updated November 2005).
- Gramm-Leach-Bliley Financial Services Modernization Act, Pub L No 106–102, 113 Stat 1338 (1999).
- Directive 89/646/EEC [1989] OJ L386/1, replaced by Directive 2006/48/EC [2006] OJ L177. The Second Banking Directive allowed deposit-taking European Banks to also engage in the kind of investment market activities that were usually reserved, at least outside of Germany, for securities firms and non-deposit taking investment banks.
- Reuters, “Key Parliament Committee Backs UBS Rescue Package”, 21 November 2008, available at http://www.reuters.com/article/rbssFinancialServicesAndRealEstateNews/idUSLL50399520081121 UBS (accessed 24 November 2008); Spiegel.com, “Rescue Package Approved—German Cabinet Agrees on Conditions for Bank Bailouts”, 20 October 2008, available at http://www.spiegel.de/international/business/0,1518,585156,00.html (accessed 24 November 2008).
- US Department of Treasury, “Blueprint for a Modernized Financial Regulatory Structure” (March 2008).
- Tripartite Authorities (HM Treasury, FSA, BoE), “Financial Stability and Depositor Protection: Further Consultation” (Cm 7436, July 2008); FSA, “Review of the Liquidity Requirements for Banks and Building Societies” (December 2007).
- FSF, “Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience”, 7 April 2008 (hereinafter, FSF, “Enhancing Market Resilience”) and “Interim Report to the G7 Finance Ministers and Central Bank Governors”, 5 February 2008 (hereinafter, FSF, “Interim Report”); Basle Committee on Banking Supervision, “Liquidity Risk: Management and Supervisory Challenges” (February 2008).
- The President’s Working Group on Financial Markets, “Policy Statement on Financial Market Developments” (March 2008).
- For a critical overview of regulatory responses to the global credit crisis see C Goodhart, “The Regulatory Responses to the Financial Crisis”, mimeo, LSE-FMG (March 2008).
- PFUE, “Informal Meeting of the Heads of State and Government of the European Union on 7 November”, 7 November 2008.
- The framework agreed by the G 20 leaders includes, inter alia, a commitment to: “improvements to financial market transparency and ensuring complete and accurate disclosure by firms of their financial conditions—making sure banks and financial institutions’ incentives ‘prevent excessive risk taking’—asking finance ministers to draw-up a list of financial institutions whose collapse would endanger the global economic system—strengthening countries’ financial regulatory regimes—taking a ‘fresh look’ at rules that govern market manipulation and fraud.” The Declaration of the Summit on Financial Markets and the World Economy containing all agreed policy initiatives can be found at http://www.whitehouse.gov/news/releases/2008/11/20081115-1.html (accessed 16 November 2008).
- M Friedman, “The Methodology of Positive Economics” in M Friedman, Essays in Positive Economics (University of Chicago Press, 1953), 3.
- C Hommes and F Wagener, “Complex Evolutionary Systems in Behavioral Finance” in T Hens and KR Schenk-Hopp (eds), Handbook of Financial Markets: Dynamics and Evolution (Amsterdam, Elsevier Science & Technology, 2009).
- In the specific context, “Endogenous risk means that any financial assets fluctuations are … explained only by the very behavior of the participant or the participants that prize that financial asset, and not by exogenous factors … [such as] … changes in the economic environment, changes in the profitability of the company, changes in cash flows … [i]t’s simply … [market actors’] own behavior that creates this … risk” (L Fischer, ‘Major Risks of International Banking’ in P Nobel and M Gets (eds), Law and Economics of Risk in Finance (Zürich, Schulthess, 2007), 124).
- See, eg K Alexander, J Eatwell et al, “Financial Supervision and Crisis Management in the EU”, prepared for the European Parliament’s Committee on Economic and Monetary Affairs, IP/A/ECON/IC/2007-069 (December 2007), 3–7.
- Ibid, 6–7.
- Ibid, 3.
- See S Schwarcz, “Systemic Risk”, Duke Law School, Research Paper No 163, March 2008.
- See P Samuelson, “Proof that Properly Anticipated Prices Fluctuate Randomly” (1965) 6 Industrial Management Review 41; B Mandelbrot, “Forecasts of Future Prices, Unbiased Markets, and Martingale Models” (1966) 39 Journal of Business 242.
- EF Fama, “Efficient Capital Markets: A Review of Theory and Empirical Work” (1970) 25 Journal of Finance 383; EF Fama, “Efficient Capital Markets II” (1991) 46 Journal of Finance 1575.
- RJ Gilson and RH Kraakman, “The Mechanisms of Market Efficiency” (1984) 70 Virginia Law Review 549, 560 and 565; “The Mechanisms of Market Efficiency Twenty Years Later: The Hindsight Bias” (2003) 28 Journal of Corporation Law 715, 723.
- GM Frankfurter and EG McGoun, “Market Efficiency or Behavioral Finance: The Nature of the Debate” (2000) 1 Journal of Psychology and Financial Markets 200; RJ Shiller, “From Efficient Markets Theory to Behavioral Finance” (2003) 17 Journal of Economic Perspectives 83, 96–101.
- See, in general, N Barberis and R Thaler, “A Survey of Behavioral Finance”, National Bureau of Economic Research, Working Paper No 9222 (September 2002), 4 and 13; D Hirschliefer, “Investor Psychology and Asset Pricing” (2001) 56 Journal of Finance 1533; EF Fama, “Market Efficiency, Long-term Returns, and Behavioral Finance” (1998) 49 Journal Financial Economics 283.
- The other pillar of BDT is experimental economics.
- See Barberis and Thaler, supra n 31.
- D Kahneman and A Tversky, “Judgment under Uncertainty: Heuristics and Biases” (1974) 185 Science 1124. See also JT Harvey, “Heuristic Judgement Theory” (1998) 32 Journal of Economic Issues 47.
- A Tversky and D Kahneman, “Extensional vs Intuitive Reasoning: The Conjunction Fallacy in Probability Judgment” (1983) 90 Psychological Review 293.
- See A Tversky and D Kahneman, “Availability: A Heuristic for Judging Frequency and Probability” (1973) 5 Cognitive Psychology 207.
- See L Rosenthal and C Young, “The Seemingly Anomalous Price Behavior of Royal Dutch/Shell and Unilever NV/PLC” (1990) 26 Journal of Financial Economics 123; KA Froot and EM Dabora, “How are Stock Prices Affected by the Location of Trade?” (1999) 53 Journal of Financial Economics 189. This paradox was also examined in A Shleifer and R Vishny, ‘Limits of Arbitrage’ (1997) 52 Journal of Finance 35.
- Barberis and Thaler, supra n 31, 41.
- MCC Lee, A Shleifer and RH Thaler, “Investor Sentiment and the Closed-end Fund Puzzle” (1991) 46 Journal of Finance 75; N Chopra, MCC Lee, A Shleifer and R Thaler, “Yes, Discounts on Closed-end Funds Are a Sentiment Index” (1993) 48 Journal of Finance 801.
- See Barberis and Thaler, supra n 31, 41.
- In fact, Lee, Shleifer and Thaler found that there is a strong co-movement in the prices of closed-end funds, which is a powerful indication that noise trader risk is systematic. See supra n 39.
- See on stock market overreaction WFM DeBondt and R Thaler, “Does the Stock Market Overreact?” (1985) 40 Journal of Finance 793 and “Further Evidence on Investor Overreaction and Stock Market Seasonality” (1997) 42 Journal of Finance 557.
- RJ Shiller, “Measuring Bubble Expectations and Investor Confidence” (2000) 1 Journal of Psychology and Financial Markets 49.
- ND Weinstein, “Unrealistic Optimism about Future Life Events” (1980) 39 Journal of Personality and Social Psychology 806.
- See Shiller, supra n 43.
- See supra nn 22 and 23.
- R Mehra and E Prescott, “The Equity Premium: A Puzzle” (1985) 15 Journal of Monetary Economics 145; NR Kocherlakota, “The Equity Premium: It’s Still a Puzzle” (1996) 34 Journal of Economic Literature 42. For a behavioural analysis see S Benartzi and RH Thaler, “Myopic Loss Aversion and the Equity Premium Puzzle” (1995) 110 Quarterly Journal of Economics 73.
- R Shiller, “Do Stock Prices Move Too Much to Be Justified by Subsequent Changes in Dividends?” (1981) 71 American Economic Review 421. SF LeRoy and RD Porter, “The Present-value Relation: Tests based on Implied Variance Bounds” (1981) 49 Econometrica 555.
- T Odean and B Barber, “Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors” (2000) 55 Journal of Finance 773.
- Andrew Lo, a leading financial economist, calls this fusing approach the “Adaptive Markets Hypothesis”. A Lo, “Reconciling Efficient Markets with Behavioral Finance: The Adaptive Markets Hypothesis” (2005) 7 Journal of Investment Consulting 21.
- See, inter alia, S Jagger, “Sub-prime and Banking Crisis: Who Caused this Nightmare? The Blame Spreads”, The Times, 19 March 2008, available at http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article3579171.ece (accessed 10 May 2008).
- See the FSF, “Interim Report”, supra n 15; PWGFM, supra n 16; IMF, supra n 6; M Carney, Governor of the Bank of Canada, “Addressing Financial Market Turbulence”, Remarks to the Toronto Board of Trade, 13 March 2008, 3. See also BS Bernanke, “Addressing Weaknesses in the Global Financial Markets: The Report of the President’s Working Group on Financial Markets”, speech made at the World Affairs Council, 10 April 2008.
- See supra n 19.
- For behavioural explanations of the meltdown of the US sub-prime market see SL Schwarcz, “Protecting Financial Markets: Lessons from the Subprime Mortgage Meltdown” Duke Law School, Research Paper No 175 (November 2007).
- PWGFM, supra n 16, 8.
- Ibid.
- Bernanke, supra n 52.
- IMF, supra n 6, 56–59, Boxes 2.1 and 2.2.
- PWGFM, supra n 16, 8.
- IMF, supra n 6, 11.
- PWGFM, supra n 16, 9–10.
- Ibid.
- Ibid.
- Bernanke, supra n 52.
- Carney, supra n 52.
- This concept describes individuals’ limited ability to process information because they possess “limited computational skills and seriously flawed memories”. Bounded rationality was first discussed as a potential determining factor in decision-making by Herbert Simon. See HA Simon, “A Behavioral Model of Rational Choice” (1955) 69 Quarterly Journal of Economics 99 and “Rational Choice in the Structure of the Environment” in HA Simon, Models of Man: Social and Rational (New York, Wiley & Sons, 1957), 261, 271.
- Carney, supra n 52.
- The most common credit derivatives used for this purpose are credit default swaps (CDS). These are financial contracts in which two parties agree that one party pays the other a fixed periodic coupon for the specified life of the agreement. The other party makes no payments unless a specified “credit event” occurs. Credit events are typically defined as including a material default, bankruptcy or debt restructuring for a specified reference asset.
- IMF, supra n 6, 69.
- Ibid, 70–72.
- S Gilani, “The Real Reason for the Global Financial Crisis … the Story No One’s Talking About”, Moneymorning.com, 18 September 2008, available at http://www.moneymorning.com/2008/09/18/credit-default-swaps (accessed 26 November 2008).
- S Foley, “US Fed Rides to the Rescue of AIG with $85bn Bail-out”, The Independent, 18 September 2008, available at http://www.independent.co.uk/news/business/news/us-fed-rides-to-therescue-of-aig-with-85bn-bailout-934252.html (accessed 17 November 2008).
- IMF, supra n 6, 55.
- Ibid.
- For an excellent analysis of the CRAs’ paradox see SL Schwarcz, “Private Ordering of Public Markets: The Rating Agency Paradox” (2002) University of Illinois Law Review 1; see also HE Jackson, “The Role of Credit Rating Agencies in the Establishment of Capital Standards for Financial Institutions in a Global Economy” in E Ferran and CAE Goodhart (eds), The Challenges Facing Financial Regulation (Oxford, Hart Publishers, 2001).
- International Organisation of Securities Commissions (IOSCO), “Code of Conduct Fundamental for Credit Rating Agencies” (December 2004).
- PWGFM, supra n 16, 15.
- FSF, “Interim Report”, supra n 15, 4.
- For an analysis of the impact of the principal-agent relationship (within financial institutions) on the failure of disclosure in the market for structured credit securities see SL Schwarcz, “Disclosure’s Failure in the Subprime Mortgage Crisis” Duke Law School, Research Paper No 203 (March 2008), 8–9.
- See J Chevalier and G Ellison, “Career Concerns of Mutual Fund Managers” (1999) 114 Quarterly Journal of Economics 389.
- P Gompers and A Metrick, “Institutional Investors and Equity Prices” (2001) 116 Quarterly Journal of Economics 229; R Wermers, “Mutual Fund Herding and the Impact on Stock Prices” (1999) 54 Journal of Finance 58; see also DS Scharfstein and J Stein, “Herd Behavior and Investment” (1990) 80 American Economic Review 465.
- DC Langevoort, “Taming the Animal Spirits of the Stock Markets: A Behavioral Approach to Securities Regulation” (2002) 97 Northwestern University Law Review 135, 158–59.
- PM Healy and K Palepu, “Governance and Intermediation Problems in Capital Markets: Evidence from the Fall of Enron” (2003) 17 Journal of Economic Perspectives 3.
- See supra n 19.
- For the limited impact of disclosure on structured credit markets see Schwarcz, supra n 79.
- P Webster, G Hurst and S Kennedy, “Northern Rock Nationalisation Runs into £49bn Granite Barrier”, The Times, 21 February 2008, available at http://www.timesonline.co.uk/tol/news/politics/article3406368.ece (accessed 10 May 2008).
- Carney, supra n 52, 4.
- Institute of International Finance, “Interim Report of the IIF Committee on Best Market Practices”, 9 April 2008.
- CESR, “Second Report to the European Commission on the Compliance of Credit Rating Agencies with the IOSCO Code and the Role of Credit Rating Agencies in Structured Finance”, CESR/08-277 (May 2008), 3–4.
- “Proposal for a Regulation of the European Parliament and of the Council on Credit Rating Agencies”, COM(2008) 704 final, 12 November 2008.
- Washington Declaration, supra n 19; FSF, “Enhancing Market Resilience”, supra n 15, 42.
- For the merits and complications of such a proposal see BS Bernanke, “Hedge Funds and Systemic Risk”, speech at the Federal Reserve Bank of Atlanta 2006 Financial Markets Conference, 16 May 2006. On the systemic risk implications created by hedge fund activity and possible regulatory responses see PWGFM, “Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management”, Report-3097, 15 April 1999.
- On 23 September 2008, the European Parliament adopted the Rasmussen Report on Hedge funds and Private Equity and called the European Commission to submit to Parliament, “a legislative proposal or proposals on the transparency of hedge funds and private equity”. The Rasmussen Report, inter alia, calls for capital requirements to be imposed on hedge funds. See “Resolution of 23 September 2008 with Recommendations to the Commission on Hedge funds and Private Equity”, EP 2007/2238(INI).
- Carney, supra n 52, 7.
- The individual and collective culture of greed within financial institutions is also held to be the main cause for the failure of regulatory and institutional risk controls to prevent rogue traders. See KD Krawiec, “Accounting for Greed: Unraveling the Rogue Trader Mystery” (2000) 79 Oregon Law Review 301.
- Sarbanes-Oxley Act 2002, 15 USC §§ 7201–7266 (2002).
- Cf M Wolf, “Why Regulators Should Intervene in Bankers” Pay,” Financial Times, 16 January 2008, 11.
- See supra nn 13–14.
- See HM Treasury, “Financial Stability and Depositor Protection: Special Resolution Regime”, Cm 7459 (July 2008).
- “Conglomeration is clearly a major homogenising force too. As conglomeration proceeds risk management procedures acquire common characteristics throughout the financial sector, whether in banking, securities, fund management or insurance.” Alexander et al, supra n 23, 5.
- FSF, “Enhancing Market Resilience”, supra n 15, 12–18.
- IMF, supra n 6.
- It has been suggested that, in the absence of other regulatory safeguards, capital adequacy requirements cannot ensure bank stability. See JR Barth, G Caprio Jr and R Levine, “Bank Regulation and Supervision: What Works Best?”, NBER Working Paper No W9323 (November 2002), 34.
- FSF, “Enhancing Market Resilience”, supra n 15, 19–31.
- Schwarcz, supra n 26, supra n 28, 34–35 and 63.
- For an exposition of the market failures, such as information asymmetries, and other policy concerns, such as banking runs and the risk of contagion, which underpin banking regulation see R Cranston, Principles of Banking Law (Oxford University Press, 2nd edn, 2002), ch 3; R Dale, The Regulation of International Banking (London, Prentice Hall, 1984), ch 3.
- This proposal should not be confused with the insightful literature and policy recommendations, developed under the tutelage of Lord Eatwell, regarding the need to establish a World Financial Authority with systemic stability responsibilities. Inter alia, see J Eatwell and L Taylor (eds), International Capital Markets, Systems in Transition (Oxford University Press, 2002), chs 2 and 5.
- See IMF Press Release No 08/97, “International Working Group of Sovereign Wealth Funds is Established to Facilitate Work on Voluntary Principles”, 1 May 2008.
- Systemic risk is defined here as the likelihood that a series of defaults of bank counterparties can lead, within a short period of time, to banks’ inability to pay their obligations to each other causing a series of institutional collapses and a possible depositors’ run. See GG Kaufman, “Bank Failures, Systemic Risk, and Bank Regulation” (1996) 16 The Cato Journal 17, 20.
- IMF, supra n 6, 32–33.
- Ibid, 22.
- IMF, Financial Stress and Deleveraging, supra n 3, 20–21.
- For a first approach to providing a metric of systemic stability see C Goodhart and DP Tsomokos, “Analysis of Financial Stability”, mimeo, LSE-FMG, 2008.
- As a moral and political principle, the precautionary principle is used to support (health and safety/environmental) regulation even in the absence of scientific evidence, when there is a threat (an action or policy) that could cause very serious or irreversible harm to the public. Thus, it may justify, in certain cases, the cost of protective regulation, regardless of a cost benefit analysis. Schwarcz, supra n 28, 63–66 has stressed the role of the precautionary principle in justifying regulation that protects the financial system from systemic risk.
- Barth et al, supra n 103.
- See JR Barth, RD Brumbaugh and JA Wilcox, “The Repeal of Glass-Steagall and the Advent of Broad Banking” (2000) 14 Journal of Economic Perspectives 191; S Claessens and D Klingebiel, “Competition and Scope of Activities in Financial Services”, mimeo, World Bank, April 2000.
- Barth et al, supra n 103, 31–32.
- R Levine, N Loayza and T Beck, “Financial Intermediation and Growth: Causality and Causes” (2000) 46 Journal of Monetary Economics 77.
- Alexander et al, supra n 23, 5, 7.
- supra n 103.
- E Dash and J Creswell, “The Reckoning—Citigroup Saw No Red Flags Even as It Made Bolder Bets”, New York Times, 23 November 2008, A1.
- T Beck, A Demirguc-Kunt, R Levine and V Maksimovic, “Financial Structure and Economic Development: Firm, Industry, and Country Evidence” World Bank Policy Research Working Paper 2423 (June 2000); RG Rajan and L Zingales, “Financial Systems, Industrial Structure, and Growth” (2001) 17 Oxford Review of Economic Policy 467.
- Barth et al, supra n 105, 34–35. Barth et al conclude that “[c]ountries that do not impose severe limits on foreign bank entry enjoy greater banking-sector stability” (idem, 38).
- See DW Diamond and RG Rajan, “Liquidity Shortages and Banking Crises” (2005) 60 Journal of Finance 615.
- B Holmström and J Tirole, “Private and Public Supply of Liquidity” (1998) 106 Journal of Political Economy 1.
- DW Diamond and PH Dybvig, “Banking Theory, Deposit Insurance, and Bank Regulation” (1986) 59 Journal of Business 55.
- AK Kashyap, R Rajan, and JC Stein, “Banks as Liquidity Provider: An Explanation for the Coexistence of Lending and Deposit-Taking” (2002) 57 Journal of Finance 33.
Journal of Corporate Law Studies
Volume 9, 2009 - Issue 1