Panel: Legal perspectives on macroprudential regulation
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Transkript: Englisch(automatisch erzeugt)
00:16
Yes, it seems to be functioning. Welcome to all of you.
00:20
It's a great pleasure to follow the President in kicking off this conference, the second annual conference of the ESRB. I'm Richard Portis. I'm the chair of the Advisory Scientific Committee of ESRB and co-chair of the Joint Expert Group on Shadow Banking.
00:41
And it's in those capacities that I'm here and that I'm chairing the first session of this panel. You might have asked yourselves, looking at the program, why this panel? What's the need for a panel talking about law? I mean, we're here, but we're regulators, we're finance people, we're economists.
01:02
We're not lawyers. Well, that's the point. You're not, right? Neither am I. I might have been one long ago, I was certainly thinking about it, but I didn't. I ended up marrying a lawyer. That was fine, except we divorced and, you know, everybody, we're on very good terms.
01:23
Everybody should have a lawyer in the family. Unfortunately, neither of my older children, at least, are interested. So I've had to do a bit myself, and that initial experience taught me quite a lot. That was, I'm chair of the Wiseman Committee of the MTS, which as most of you will know,
01:46
is the electronic platform trading government bonds in Europe. And it doesn't do very much, fortunately, because it's only called into action when there is a problem, when there's an issue. When some, in particular, when some participant in the market may have misbehaved.
02:04
And there was a spectacular event of misbehavior in August 2004, when Citibank, its European capital markets division, mounted a coordinated attack, and that's the only word for it,
02:22
on MTS, in which it effectively sold all up to the limits of what was possible and hedged on Europe. That put the market into chaos, right?
02:42
Trading stopped for several hours in some cases, for a couple of days in other cases. And this market disruption was so serious that the regulators, first of all, got involved. The home regulator, in fact, of MTS was the British, then the Financial Services Authority,
03:05
and they ultimately assessed the penalty. And then other national regulators acted, and finally it came around to the governing body of the exchange itself, and we, the Wiseman Committee, had to adjudicate to what extent
03:24
this action had violated the rules of the exchange. To what extent these were legally backed was itself a question. What legal force we could invoke, right, as a panel of three in judging this.
03:44
We, what evidence should we look at? And we had stacks and stacks of emails and trade records and so forth on the day. And we spent a day dealing with the representatives of Citi and their lawyers, who were excellent.
04:05
And it was, intellectually, it was a very, very interesting experience. The three of us on the panel were our economists, finance professors, and so forth. And we learned, as they say, we learned a great deal.
04:20
But what we learned, most importantly, aside from the way in which market abuse is defined and how you deal with it, was the importance of the institutional framework underlying markets and the legal framework underlying markets.
04:41
And that, I think, is where I started from, where I start from, when I think about the issues this panel is going to be addressing. The legal and institutional framework, in this case, underlying macroprudential policy. The European Commission has just published proposals for some changes to the regulatory
05:08
framework, in particular to ESRB, among others. And it would be useful, I think, when the appropriate authorities consider these proposals to go back to the legislative history.
05:22
What did the Commission, where did the original proposals for ESRB and the associated institutions, where did they come from? What was the Commission's reasoning? When the Parliament discussed this, what did the report look like?
05:40
What were the intentions of the legislators and the Council when it came to that? I think that legislative history should be considered when thinking about where to go forward, how to go forward, the extent to which ESRB has fulfilled the roles that were intended for it.
06:02
And then we come to the issues which our panel will be discussing. There's a quite wide range, as you will see. Federalism, for example. The respective roles of the ESRB and the NCAs. It's funny, in my time involved with the ESRB, I've never once heard the word
06:26
subsidiarity, not once. And that may or may not say something, but it's worth considering. What are the powers of the respective agencies? What is the legitimacy?
06:42
What is the accountability of these institutions? And what are the legal basis for the various tools? What is the legal basis for the various tools that are used in macroprudential policies? All these issues will be dealt with by our panel.
07:04
Each of them will have 15 minutes to do an initial presentation. There will then be an exchange among the panelists. And we've left quite enough time, I think, for a very good Q&A session. And I expect you all to be involved in that and to be responsive and to raise difficulties,
07:27
to raise problems. That's what we academics are for, is to try to consider such problems. So I will introduce very quickly the panelists. And we will start with Anna Gelpern, who is professor of law at Georgetown University
07:46
in the United States and a research fellow of the Peterson Institute for International Economics. Then we will hear from Eric Posner, who is professor of law at the University of Chicago Law School.
08:01
And finally, we will have Kern Alexander, professor of law and finance at the University of Zurich. And this is a really outstanding panel of lawyers who are very, very closely familiar with and knowledgeable about financial systems and financial regulation.
08:22
And I think we shall have a lot to learn from them. So, Anna, I think you should start. And your slides will go up in a moment.
08:42
Thank you very much. It's an honor to be here, Richard. You're incredibly brave and generous to put these good folks in a position to have to listen to a bunch of lawyers and hopefully we'll make it worth your while. It's an honor to be here. And my job is to situate the law as I see it in the macroprudential context.
09:11
And to get all the bad puns out of the way up front. So, okay. The reason I titled this talk Islam macroprudential is partly because there's a stereotype of law
09:27
scholars and lawyers as two things. One is reactive. So, you know, the stimulus for what we do comes from outside events or other disciplines.
09:42
And second, as extremely micro and transactionally focused. And part of my job here is to say, well, maybe part of this is true, but I don't think that it's, I don't think this holds.
10:00
And I'm going to start by looking at where were the lawyers. So, while economists were developing this concept of macroprudential policy, macroprudential regulation, what was happening in the law space, then I'm going to switch from lawyers, really legal academics, to where do you find law in macroprudential policy.
10:27
And then I will turn to, so what? You know, what do we do with this information, if anything? So, this is a very well-known, I'm sure most of you are familiar with this short essay
10:43
by Pete Clement from 2010 on the history of the term macroprudential. The word, not the idea. And as far as he and anybody else can tell, the word first appeared in public in 1986 and the definition was very much the safety and soundness of the broad financial system
11:02
and payments mechanism rather than individual institutions, which of course is the traditional microprudential focus. Well, we looked at, the Royal We, our library and I, looked at the incidence of the words macroprudential or word macroprudential
11:22
in English language law journals and found actually some mentions at around the same time. The first one was, and both of them were in the context of the sovereign debt crisis. So, the first one talked about the conflict between the microprudential perspective,
11:41
individual bank solvency, and the position of US government agencies like the Treasury, the Federal Reserve, and the State Department. I'll return to that in a moment. And the second one was talking about the position, so one was from 85 a year before that public mention in the Clement piece
12:02
and the other one was in 87, was talking about a different outlook that money center banks have as distinct from smaller regional banks and what are the stakes in the crisis. So, what was interesting to me here was that in the law journals,
12:24
it's on the one hand echoing the economics discussions, we're talking about stability of the financial system as a whole from the get-go it's about international financial stability, from the get-go it's about political economy,
12:40
and very much about the government nexus. The reason there's an asterisk by the word government is that for the most part the conversation was about the fact that the interests of US money center banks were basically tied up with emerging market governments that borrowed from them. If you recall at the time if they defaulted in the mid 80s,
13:02
it would have wiped out the capital of all the big banks in the United States. So, of course there's this other implicit government standing behind this, but the framing was very much big bank fortunes are a function of emerging market government's fortunes and therefore they have a different outlook
13:23
and how do we configure policy and regulation of those big banks with these concerns in mind. What really stunned me was the mention of the State Department as a macro prudential agency. And you could say, well, this is a fluke and sort of a little flash of ignorance.
13:42
Now, the fellow who wrote this was actually not a lawyer. This may explain it, but I don't think so because he was from chemical banks. So, he was very much in the middle of this restructuring stuff and how clearly the concern with exposures was in the air and the way it migrated into the law journals
14:03
was in the context of which US government agencies would have their finger in the pot and the fact that the state was there before the Fed this is from a banker and next to the treasury to me was very interesting.
14:21
Now, this is the total results of the mentions which is very similar to the economics literature. So, the 1985 piece was not even picked up in the search and then little blips in 95, there's a teeny little blip which is exactly mirroring what's going on
14:41
in the economics and policy discussion which is concerned with derivatives. And then from 2007, 8, 9, it just takes off and everybody's macroprudential and the hyphen disappears, by the way, which is sort of interesting. So, this giant explosion, this bubble in macroprudentialism
15:06
in, again, English-language law journals and this is over-inclusive for what it's worth. Where does the writing, where does the law literature stand at the moment? So, there are different strands and I think it's important to recognize.
15:22
This is a very selective list. I deliberately excluded all of our writings because you're going to hear from us anyway and you know who we are. But it's also just to give you a flavor of different ways in which this comes up. Most common, of course, is financial instability and financial regulatory response.
15:41
So, banking, regulatory writing retooled for the system stability rather than individual bank stability. There is an explosion of sorts, a mini pop, in law writing about money. How is money constructed?
16:01
What is the role, how does it affect the financial cycle? And there are some, again, interesting treatments that were new to the law and clearly in the macro category, whatever it is. Then there is a book by Eric Gerting,
16:22
which I think is really innovative in that he explores how regulation contributes to the financial cycle. So, there may be the business cycle, there may be the financial cycle, but there's also a regulatory supervisory cycle that can become its own source of vulnerability
16:41
that can also be pro-cyclical and I thought that framing that was original and valuable. Then there are some really kind of one-off idiosyncratic pieces. There's a piece by Joanna Gray that talks about lawyers' responsibility in structuring transactions.
17:02
So, lawyers as transaction cost engineers, lawyers as engineers of contracts, do they, who actually supposedly knew how they were putting together complex structures that imploded in the crisis, is there any responsibility on the lawyers' part?
17:21
There's the somewhat more traditional political economy in law writing. Really, that's their bank government nexus writing and how our financial markets constituted and the relationship with the government. Then there's the new and really quite distinct writing area
17:48
that's more law and macroeconomics than law and macroprudential regulation. So, you would take your ISLM or dynamic equilibrium models
18:02
and formally plug law into it. So, this is not really about finance. This is a lot more about the business cycle. Now, this is where the writing is. Now, forget about the way in which law academics and lawyers slice this.
18:21
If you were to look at where do you find the law and what do you do with it, how can it be useful to you, there are a few ways. If you read ESRB reports, the most common approach is instrumental. So, we have the objective, which we derive from the economic side.
18:45
And then we, basically the question is, so what law do we need to make it happen? And law is in quotations because sometimes we mean statutes, sometimes we mean legislation, it's different in different countries,
19:01
and it's sort of the hire a lawyer moment. I know what I want, help me make it happen. There is another way of looking at the law in the macroprudential space, and that is look at the constitutional dimension. None of these market structures were handed down from above.
19:21
They were constituted and at the highest level as part of the political bargain. So, issues like, I'm glad Richard mentioned federalism, global and regional integration, fiscal and monetary policy and authority, whether you can issue public debt, how and who decides.
19:43
Institutional questions, which are similar but distinct, you're looking at agency structure, firm structure, regulatory authority, and Kern certainly has a lot of terrific work in this space. There is also purely private law.
20:01
Contracts can be systemically important. I give you derivatives, right? And the standardized contracts in ISDA space where if something goes wrong, it goes wrong with everything, right? And I'll have another example down the line. And then there is the law as a source, as an endogeneity problem, a version of that, right?
20:21
So, the internal problem and the feedback mechanisms with how the law constitutes either financial regulation or issues of power allocation authority. So, these are just some examples that might not be, that are not generally talked about.
20:42
In the United States, as many people know, states have constitutional debt limits. You can't, it's all pay as you go. Balanced budget. Well, if that happens, obviously there is a pro-cyclical effect to that. States stop spending just when you might want them to spend. Your question is then, well, who's going to make up for it?
21:02
And that's where questions of federalism come up. All of this is not just legal, but this is kind of the bread and butter lawyers, the real lawyers, the constitutional folk. Not the esoteric financial regulatory folk that operate in this space normally.
21:21
Employment regulation. I found out recently that in Canada most employment is regulated at the province level. Well, what does that do with your worries about unemployment and how you affect unemployment? And Eric, I think, might touch on that because he's written about it. This is going back to contracts and money.
21:42
I mentioned derivatives. Of course, there's a much older example. This is the famous gold clause cases in 1935. All the contracts, all the long-term debt contracts in the U.S. were indexed to gold. Gold clauses were stripped. And again, very mainstream legal stuff, but certainly macroprudential.
22:04
Now, I'm going to wrap up. So what now? This will look familiar, right? I wanted to read the ESRB report from the legal perspective, I guess whatever that might be, from some or all of the perspectives I saw there.
22:22
And it's fascinating because it reads as an unbelievably technical exercise, and at every step we're getting more granular, more impressively sort of precise, and the objective is to plug the loopholes.
22:41
What I can't see from this is the big structures that I just talked about that tend to frame our thinking. And instead what you get, this is not ESRB, this is actually FSB, is sort of when we're all done with these really complicated pictures, the sun rises and the shadow banking sector is transformed into resilient market-based finance.
23:02
But the big structures are not readily apparent, and I think that that's a political, policy, and constitutional problem. So in my last 32 seconds, so what do we do with that? So I think when we think about the law, we need to think about it both as a source of norms,
23:25
problems, and structures rather than just an instrument to do somebody else's job. Law and macro is not just about regulation, but it involves big political issues, legitimacy distribution.
23:42
Therefore this brings us back to the bank-government nexus, which is one of those big questions that's very hard to plot. International political economy. Is it about a new – so to me the more interesting question is what is the frame? What can we contribute to the frame rather than to the toolkit?
24:04
And of course the famous Andrew Crockett speech from I think it was 2000, he emphasized that the crux of macroprudential thinking is with the objective and the conception rather than the tools. It doesn't mean we don't bring new tools to the picture.
24:22
It doesn't mean we don't care about the tools, but I think law can make a bigger and better contribution if we're not just being instrumental about it. So thank you very much.
24:48
Okay, so thank you, Richard, for inviting me to present here. Richard asked me to talk about a paper I wrote with a co-author named Jonathan Mazur called Should Regulation Be Countercyclical?
25:01
Another way you could think about this paper is should regulation be macroprudential? And of course you might say to yourself, well, of course financial regulation should be macroprudential or maybe not, of course, but this paper and my thoughts are based on a broader topic,
25:21
which is whether all regulation should be macroprudential. So I only have three slides, so don't panic if I linger too long on the first one. I took the instructions to have three slides literally, unlike my co-panelists.
25:40
So I just took my 15 slides and I compressed them into three slides. So here we go. So as you all know, I don't need to tell you that there are two major macroeconomic tools, monetary policy and fiscal policy. And what I want to ask is whether we shouldn't be thinking about a third macroeconomic tool,
26:01
which I'm going to call regulatory policy. Now, I don't just mean financial regulation here. I mean all regulation. And so I'm using regulation here in a somewhat technical sense, but I just mean the ordinary ways that we use the word, environmental regulation or pollution control regulation,
26:22
employment regulation like the minimum wage, maximum hours law, food safety regulation, insurance regulation, and so forth. And it's useful to think in terms of a regulatory stimulus analogous to either the type of stimulus that a central bank might create through monetary policy
26:46
or through fiscal stimulus where the government spends money in order to try to get the economy to grow again. And I'm going to explain in more detail what this might mean.
27:01
Before I get to it, I want to try to overcome a little bit of skepticism. So people might ask, so regulatory stimulus means suspending regulations, weakening them, withdrawing them. Could that really have a stimulative impact? And the answer is, at least in principle, it could.
27:22
Academic research on the types of traditional stimulus programs that have been undertaken by OECD countries over the last, let's say, 10 or 20 years indicates that they typically range from about 1 to 5 percent of GDP. So the big stimulus package in the United States
27:43
that was issued during the Great Recession was about 5 percent of GDP. Automatic stabilizers are typically around 1 percent of GDP in practice. Now in the United States, if you add up all of the costs of regulation,
28:01
you get something like 1 percent of GDP. And I'm sure in other countries, the amount is either comparable or higher. So at least in principle, if you suspended regulation, you could make a dent similar to the effect of traditional types of stimulus.
28:21
Now of course, no country would eliminate all of its regulation during a recession. That would make little sense. So that 1 percent is obviously a ceiling, and one suspects the actual amount is considerably less. Okay, so what would a regulatory stimulus look like? Now I'm going to give you a real world example of a regulatory stimulus
28:42
in a few minutes to try to address your skepticism. But let's start with one that everybody is familiar with, which is in capital adequacy regulations. So as you know, the traditional approach to capital adequacy regulations is to think of them as just a way of deterring banks from externalizing risk on the market.
29:04
And so you look at how banks might be influenced by deposit insurance or the implicit guarantee or other regulations such as limits on liabilities to create excessive risk, okay? And then you impose capital regulations to deter the banks
29:23
from engaging in excessively risky lending or asset purchasing. And then at some point, people began to realize that this kind of wooden microprudential approach could have bad systemic consequences because during the recession, as banks' assets lose their value,
29:41
the capital adequacy rules would cause them to withdraw credit, which could further exacerbate the recession. And so the idea was a macroprudential approach needs to be taken so that the capital adequacy regulations are countercyclical rather than procyclical, okay? And this has been introduced in Basel and in government regulation.
30:04
And while I think it's controversial, it seems to be at this point an accepted way of going about bank regulation. Now let's turn to the non-financial area of regulation. In the case of environmental regulation, at least in the United States,
30:24
agencies typically ask whether a particular regulation creates benefits that are greater than the costs. And so the benefits obviously are usually health benefits, cleaner air, cleaner water, benefits for recreation and so forth. And in principle, those can be monetized.
30:42
And then the costs are the costs for, let's say, factories to add pollution, abatement devices, and other, whatever, machinery or labor that's necessary to reduce emissions. And then a rule is created. The rule says you may not dump more than a certain type of chemical into the waterways,
31:04
or you cannot emit more than a certain amount of particulate matter into the atmosphere. Now here's the macro approach, and it might surprise you. But in 2011, in the midst of the Great Recession, the Obama administration was prepared to issue a pollution regulation
31:21
that was supposed to help protect people from ozone regulation. And when this regulation was introduced, before it was put into effect, people in the administration said, hey, wait a second, wouldn't this regulation actually worsen the recession? Because firms, if they're going to spend money in order to come into compliance with the regulation,
31:42
may have to fire workers. And in a period of suppressed aggregate demand and unemployment, that could be a really terrible thing. And so the Obama administration did withdraw the regulation and did not actually issue it until four years later in 2015 after the labor market had recovered and the recession was over.
32:04
So this is an ad hoc approach to, you might call it an ad hoc macroprudential approach to nonfinancial regulation. And it's easy, once one thinks in this way, to extend these ideas into all kinds of areas of regulation. I put workplace safety on the slide.
32:22
I really meant employment regulation in general. Economists are always saying to governments, you should liberalize or deregulate employment rules because they create these rigidities in the market that could exacerbate the business cycle. That's actually a macroprudential argument.
32:41
Labor law, employment law typically doesn't reflect such considerations. But one could imagine employment law that did, employment law that was highly protective to workers during economic booms, but then the protections were weakened somewhat during recessions so that employers would hire more people to get the economy out of recession.
33:06
And one suspects that these types of considerations influence, for example, immigration regulations, where again there's always an impulse during a recession to cut down on immigration and then during a boom to attract it.
33:21
But people in government rarely think about these sorts of regulations from a macroprudential perspective. Now, having laid out something like a case for macroprudential nonfinancial regulation, let me now acknowledge the many, many problems with this approach.
33:45
The first point is that often regulations in this context of nonfinancial regulations require firms to incur a high fixed cost at the beginning of a period and then to incur much lower variable costs later on.
34:02
So, for example, pollution regulation might tell a firm to change its production process by a lot of expensive machinery. That's very expensive. But once it's in place, it's relatively cheap to maintain that machinery and maybe you hire a few workers to operate it. Well, if a firm has already sunk costs as a result of this regulation
34:24
and then a recession strikes, it's obviously not going to be able to reverse these sunk costs if the regulation is suspended. And so it wouldn't make much sense to suspend such a regulation unless the variable costs going forward are extremely high.
34:43
Another problem with this sort of regulatory stimulus idea is that the firm, if it saves money as a result of the suspension of a regulation, will not necessarily use it to hire more workers. Of course, this is a problem that you also see in the area of fiscal stimulus
35:02
and monetary stimulus where you don't know whether the savings that are given back to taxpayers or given to firms or the lower cost of credit will actually lead to spending or lending that would be useful for getting the economy out of the recession.
35:21
But it is another problem. And then there's a third problem which has to do with what I call the stimulative effect of the regulatory obligation itself. So a regulation that tells companies to buy new pollution abatement equipment may very well cause the firm to spend what it wouldn't otherwise spend.
35:40
And so it's possible that the actual act of complying with the regulation will have a stimulative effect. And there's a very large literature about whether regulation has any effect on unemployment and it's inconclusive literature reflecting this complexity that when firms try to comply with regulations they often end up hiring people
36:02
even though their cost of productions might go up causing them to fire another group of people. And then finally if you're going to try to stimulate the economy by suspending pollution regulations you've got to worry about the health effects on people. That's a dead weight cost. So if the pollution in the atmosphere gets worse and people inhale that and become sicker
36:26
this is a social cost that is what justifies the regulation in the first place. Now if the economy is doing very badly it may be worth incurring that social cost but there's nothing like this when you engage in the traditional types of monetary or fiscal stimulus.
36:44
And then there are a set of legal problems that arise in the context of regulatory stimulus or regulatory macroprudential problems. In the United States and in most countries regulation is divided among lots of different agencies and so if you really wanted them to engage in regulatory stimulus
37:04
you'd have to make sure that they're coordinated in some way. Now one way to coordinate them would be to put them under the authority of the central bank. When the central bank determines that there's a recession and starts cutting interest rates maybe at the same time agencies should start deregulating.
37:22
But that would be a problem that would have to be addressed. And then also in probably all countries, certainly in OECD countries issuing regulations is a complex process which involves giving people notice, allowing people to comment often judicial review of some type.
37:43
And so agencies tend to have less flexibility than for example a central bank does. That is issuing a regulation that punishes somebody for not engaging in a certain type of behavior raises concerns about due process and other fairness values
38:01
that for whatever reason we don't think is such a serious problem when central banks act. And then the final point which I already alluded to is that it may be very difficult for agencies to identify whether there's a downturn but that's a generic problem here.
38:20
But you might think about the way automatic stabilizers work and you could think of automatic stabilizers as simply being extended from the tax and transfer system with which we're familiar and which I gather people tend to think is appropriate to the regulatory system. So just as taxes automatically go down during a recession and transfers go up
38:44
you could also have a setting where regulations automatically weaken during a recession and then become stronger during the boom. Alright, so in light of all these difficulties it seems fairly obvious
39:01
that the traditional tools of fiscal and monetary policy are superior. However, there are cases where the traditional tools of fiscal and monetary policy don't work that well. Everybody's familiar with the zero lower bound problem which we saw recently. That puts a limit on monetary policy.
39:23
And then realistically there are significant political constraints on fiscal policy. I don't need to tell Europeans that. It's also true in the United States. There's significant political resistance to borrowing and spending.
39:41
And so as these other tools become weaker and weaker it may be useful to have a supplement in the form of the regulatory stimulus or in other words counter cyclical macro prudential regulatory policy. Thank you very much.
40:06
Thank you very much. Accumulating a lot of food for thought and discussion here. And Kern will doubt let's add to it. Thank you Mr. Chairman and distinguished members of the panel and attendees of the ESRB annual conference.
40:24
It's a pleasure for me to be back in Frankfurt and at the ECB to meet with you and to discuss some of the issues related to legal perspectives on macro prudential regulation. But before I do so I recognize that most of you are economists and finance specialists in the room
40:40
and I'm a lowly law professor but I want to, this reminds me of an instance 20 years ago when I was a newly appointed lecturer at Cambridge University and I was teaching company law and banking law in my first few years as an academic and I was invited by a group of eminent economists from the Cambridge economics department
41:04
and the Cambridge finance group to come to one of their research meetings. They were engaged in a research project on the regulation of systemic risk after the Asian financial crisis. The Asian financial crisis was just erupting and they were working on it
41:21
and they were doing some excellent work in macro prudential modeling and trying to understand systemic risk in financial markets. So I was invited to this group and I felt a little bit out of place. There were no other lawyers there. I was sort of a very junior member of the Cambridge law faculty at the time and I didn't say a whole lot and the chairman of our group looked at me
41:43
and he sensed the fact that I felt a little out of place and he said, Kern, don't worry, we've invited you to be here because you're here to tell us what we cannot do. And so I think in a way law has been viewed by economists in a limiting fashion,
42:02
that economists have big ideas, they do cost benefit analysis, they try to devise economic policy and they try to address these, in the case of regulation, systemic risk, how do we do it? But of course we're constrained by law. We're constrained by institutions. And so what I'm going to try to do for you today is to try to put forth a little bit broader vision
42:24
of what I think law can do in the area of macro prudential regulation. So what I want to do, I've got just a few minutes, I'm going to touch on the broad contours of macro prudential policy. Macro prudential regulation is broad.
42:42
It's about monitoring the financial systems. We've just heard two excellent presentations in which this is a concept that's been defined over the last 30 or 40 years in a rather broad way, looking at the structure of financial markets, linking monetary policy, fiscal policy, regulation, and also the design of institutions, who should be doing what.
43:04
And so I want to briefly mention those issues, but then I want to go into some of the issues that concern how will macro prudential regulation and supervision be discharged? I mean, how will these responsibilities, how can they be performed in an efficient way
43:22
while adhering to principles of the rule of law? And so I'll talk about the issue of independence versus accountability. I use the word the strong form of independence because internationally, most of you are aware that central banks in most jurisdictions are the institutions that are taking the lead in macro prudential policy and regulation.
43:43
They play an important role in that area. Even now the ECB is a bank supervisor as of 2013, and so we see in the ESRB, of course, its secretary that's here at the ECB. But then I want to point out that given this balance between independence and accountability,
44:02
there are certain issues that central banks should be aware of, certain risks that they should consider regarding the exercise of macro prudential powers. And then I will mention very briefly some of the issues regarding the limitations of the ECB's role as a macro prudential policy institution.
44:24
So anyway, the broad contours of macro prudential policy you've seen in the previous presentations. It touches on monetary policy, fiscal policy, regulation, supervision. The regulation is the promulgation, the devising of the rules and laws of regulation.
44:41
Supervision is the exercise of discretionary oversight of the financial system. It's the decision whether or not to intervene, to forbear, or to apply sanctions in cases. And then finally we've got internationally now the importance of resolution, bank resolution. And in Europe we've got the requirement for resolution and recovery plans.
45:03
So the contours of macro prudential policy are broad. They touch on a number of areas. I've not mentioned the regulation of infrastructure, payment and settlement systems, and clearing. And we heard earlier Professor Portis talking about the issue of central clearing of derivative contracts.
45:21
And when an exchange breaks down, like the MTS, it can create a financial stability risk outside of the banking system. So these are all areas that macro prudential regulation has been trying to address. Internationally we've seen that a lot of progress has been made with the adoption of counter cyclical buffers in the area of Basel III. We see that there are now requirements in the EU and US for central clearing of derivatives, also in Hong Kong and in Switzerland as well.
45:46
And we see that internationally there's now been agreement on leverage limits for both non-systemically important institutions, but also for systemically important institutions. And finally the bank resolution frameworks, as I mentioned, they've been adopted.
46:02
But some areas have not yet been fully developed. And in the UK they're looking at the issue of further macro prudential tools, loan-to -value ratios for banks when they make mortgage loans, for instance, or loan-to-income ratios. These are areas that are not fully developed. They're being examined by the UK Financial Policy Committee.
46:21
But this is an area where macro prudential policy may be moving in the future. With respect to institutions, we see that everyone internationally, at least in the G20, has restructured regulation institutionally. In the US we've got the creation of the Financial Stability Oversight Council, which is a
46:40
systemic risk oversight body consisting of all the US federal regulators monitoring the whole US financial system. In the UK we see the complete restructuring of institutional side of regulation with the elimination of the old UK Financial Services Authority, and the creation of a Prudential Regulation Authority housed in the Bank of England, and a separate Financial Conduct Authority.
47:02
And in the EU, of course, as Professor Portis has mentioned, we've got the European Systemic Risk Board, but also we've got the three European Supervisory Authorities. And so together this institutional restructuring is designed in order to have enhanced monitoring of systemic risk across the financial system.
47:22
It's designed to link up regulators from insurance, from securities, from banking, and from central banks and monetary policy so that everyone's working from the same rule book. However, there are risks. There are legal risks and regulatory risks. And some of the questions are systemic risk boards identifying and mitigating systemic risk in a timely fashion, including the risks that emanate from policymakers themselves.
47:45
Regulation can be a source of systemic risk. We all know from Basel I how Basel I was focused only on balance sheets. It created an incentive for banks to shift their assets off their balance sheets through credit risk transfer and was the birth of the securitization industry in the late 1980s,
48:02
and was partially driven by regulatory capital charges under the Basel I framework. So we see that it's not just the markets themselves, but regulators and their rules can create financial stability risk. Now in the EU, we've got, if one were in the European Union looking at regulatory policy issues, one might, if you're looking at it from a legal perspective,
48:22
you could divide the legal structure of regulation into four areas. I would say the first area is competences. Statutes create competence. They create authority for certain bodies to do certain things, to have certain powers. That competence might be plenary or it might be partial, but nonetheless, these competences constitute authority to oversee the financial system,
48:50
to regulate the balance sheet of banks, to regulate the structure of the financial markets. Another aspect is the powers. The regulatory bodies have powers, and what I mean by powers are the ability to affect third parties,
49:06
to affect the situation of third parties like banks or individuals in the markets. Regulators, by having competences, they can exercise powers to restructure the property rights of third parties like financial institutions.
49:21
But with those powers, those powers can be broad or narrowly defined. With those powers come responsibilities, and the responsibilities can be viewed as obligations of the regulator not to act ultra vires or the regulator itself. In exercising its competence or its powers, it can be held liable for supervisory liability,
49:42
and in Europe we have a variety of different ways that supervisors can be held liable. And then finally there are tasks, and the tasks are set by statutes or set in policy objectives that are set by policymakers who could be finance ministries, parliaments.
50:02
In the case of the EU, it's the Council of Ministers, and also working with the European Parliament, they decide and assign tasks. And certainly as an illustration, Article 4 of the single supervisory mechanism regulation, we've got the competence of the ECB as a micro-prudential supervisor
50:22
to act exclusively to carry out for prudential supervisory purposes a number of specific tasks in relation to all credit institutions, what are defined as credit institutions, established in the participating member states. Supervisory competence depends on the identification by the European Council, the Council of Ministers, of its task, the assignments of what the ECB should be doing,
50:43
and that's a way to hold the ECB accountable by assigning these tasks. And so some of those tasks are licensing, monitoring the institutions, and enforcing prudential regulations. However, one gap one might say with respect to macro-prudential policy is the ECB is not really involved in the final decision to take banks into resolution.
51:03
That's, as many of you know, exercised by another authority, the Single Resolution Board. Also, in thinking about the legal dimension of regulation, we can consider regulatory policy principles that supervisors should carry out their task in an effective manner without reputational risk.
51:24
So they need to monitor the banking system well, effectively, which means don't screw it up and cause a crisis because it could come back and harm the reputation of the supervisor, and then the policymakers intervene and either change the responsibilities of the supervisor as a result.
51:42
Also, we have independence of the supervisor to take proportional and necessary measures to regulate property rights, and that certainly is a requirement of EU law. We know from the Gullweiler case and the ECB case that when regulators regulate property rights or other fundamental rights under EU law, that they have to act proportionally.
52:02
And what proportionality means is that they take necessary measures to achieve a valid, legitimate policy objective. And then, of course, a traditional policy has been the strict separation between monetary policy and supervisory task. That seems to be a general convention among most economists and regulators is that there should be a separation between monetary policy and supervisory task.
52:24
But I would submit to you that that separation in a macroprudential world should be revisited, that we should not have strict separations between monetary policy and supervision because in a macroprudential framework, they should be linked up more. And then finally, the accountability of the supervisor. To what extent do we want to hold macroprudential regulators accountable for their actions?
52:47
What type of reputational risks that they might have as a result of getting things wrong? Should they be sued? Can they, the supervisor, be held liable? So the issues of supervisory liability are very important. Now, and again, so what we see is the traditional notion of independence for central banks is now
53:09
being called into question because central banks are now being involved in macroprudential policy, macroprudential supervision in many jurisdictions. So the question is, is that the old model that allowed central banks
53:23
to be independent? Is it appropriate for central banks when they are macroprudential supervisors? Should that be revisited? Should we have such a strong form of independence like we have in the EU treaty, for instance, for the ECB as independent in pursuing its price stability objective?
53:41
Should that also be the case with respect to macroprudential supervision and even microprudential supervision as well in the SSM? Of course, the ECB is involved in only very limited areas of macroprudential policy now. That's because of the constraints of the EU treaty. And so we see the ECB providing its secretariat for the ESRB, and it
54:05
also has limited macroprudential tools under Article 5 of the single supervisory mechanism regulation. But by no means do they have plenary supervisory authority. They're not involved in deciding whether a bank is going to be resolved. They also don't supervise infrastructure like clearing houses for the CCPs
54:26
and central securities depositories. That's done by the European Securities Market Authority. So we've got some limitations in the EU context. But nevertheless, the ECB has gained new powers, at least under the SSM framework. And the question becomes, is there a risk of accumulation of responsibilities?
54:44
Is there a type of risk that central banks, including the ECB, should be concerned about by becoming a supervisor as well? It might create reputation challenges, reputation risk issues, and potential legal liabilities that they have to address in the future.
55:01
And as you know, the ESRB does not have legal powers. It was designed that way in 2010. In fact, I was working with the European Parliament on the original regulation that adopted the ESRB regulation. And the reason they didn't give the ESRB legal powers at the time was the ECB did not have supervisory powers at the time under Article 127, paragraph 6 of the treaty.
55:21
And so there was a concern that if you gave the ESRB any type of legal power, it might be interpreted as a supervisory power in violation of Article 127, 6 of the treaty. However, now we know that all parties have given the ECB supervisory competence, and they now have microprudential supervisory power.
55:43
So I would suggest that there should be a revisiting of that limitation for the ESRB. Anyway, again, these are some observations regarding the ECB framework, which I think are also very pertinent to other central banks and other jurisdictions internationally.
56:01
Central banks, of course, are engaged in monetary policy. Increasingly, more of them are involved in macroprudential supervision. This brings risk and it brings the potential for certain types of legal liabilities. It raises issues regarding whether or not supervision should be separate from monetary policy.
56:20
And of course, there's a separation currently under the law in the Eurozone regarding that. And I would suggest that more effective macroprudential regulation would require that monetary policy be linked up more with supervision. Also, and of course with the ECB, the governing council is the ultimate decision maker. So even for the supervisory authorities, if they're going to fine and penalize a bank and impose penalties on the
56:46
bank, they have to get this ultimately approved by the governing council of the ECB at the end of the day. So that raises questions about is there really separation between supervision and monetary policy if the governing council at the end of the day really makes all the decisions?
57:02
So these are issues I think need to be addressed in the future. My last slide is about bail-in. Bail-in, of course, is the subject of numerous lawsuits around the EU now. It's the issue of the execution of bail-in has led to many investors, bondholders to sue in courts to say that their fundamental right
57:21
to property has been infringed and whether or not the bail-in decision was taken in a proportional way that was necessary given the circumstances. And so the bail-in issue has led to many lawsuits, resolution authorities have got liability risks there. And if the ECB were to play a role in resolution in the future, that would be a
57:45
potential area of risk that the ECB would be exposed to, as well as any other central bank. Resolution authorities are in central banks across Europe. In the UK, the resolution directorate is in the Bank of England. So the Bank of England has got ultimately supervisory, has got legal liability for any decision to impose bail
58:06
-in or to take a bank into resolution that possibly might not necessarily should have been put into resolution. So these are issues that are a risk in the future. And the lawyers are here to help you manage the risk. And I think that, but these are complicated issues.
58:21
I mean, the financial markets are complicated. The risk in the market derived from the markets, but they also derive from the way the law has structured the markets and also from the decisions of regulators in the markets. And so I'm not really sure if there's a panacea or an answer to all these questions, but they do relate to legal risk in the future. So thank you very much indeed for listening.
58:50
And thank you, Kern. I think we can take the slides down now. And what I'd like to do is to have an exchange among the panelists. I'm going to try to provoke them a bit on a few topics and then turn to the floor for questions and comments.
59:08
Let me start with, let me set out a few issues that I think have been raised, not necessarily where there's obvious disagreement among the panelists, but where there's a potential for disagreement maybe.
59:22
The first is on the international dimension and whether in particular we can expect to see or have we seen already any significant conflicts between the United States and the European Union on macroprudential, specifically macroprudential issues and how those conflicts can be resolved.
59:42
What kind of institutional legal framework is there for resolving such conflicts? The second is on the very interesting discussion of regulatory cycles. And I guess the way I would put it, one way of putting it is have we reached
01:00:00
peak regulation. We know about peak oil and all that, and we reached peak regulation. The cycle is familiar to anybody who's lived in the UK over the past 20, 30 years. We had the Financial Services Authority in the late 1990s put out a huge rule book, and
01:00:21
then a few years later completely tear it up and go to principles-based regulation, which then was heavily criticized, of course, when the crisis came. And now one could claim that, and some of the discussions I observe and participate in in the committees that I'm
01:00:42
involved in here certainly suggest this, there is a certain degree that I've noticed of regulators trying to cover themselves against possible risks that somebody may blame them in future. For missing a risk here or there, and therefore let's just try to regulate it,
01:01:06
right? Make sure it doesn't happen. Well, of course, there are costs to regulation, and sometimes those aren't really fully addressed. The counter cyclical buffer we have,
01:01:22
as Dr. Draghi said, all the countries have adopted this, but only four countries have put in place a number, an amount. And by the way, of course, it should be symmetric. The CCB should not be there just to operate in a downturn. It should be there to operate in a
01:01:42
boom, and both ways. But you can't operate, you can't use it in a downturn unless you've got it in place already, unless there's something to relax, as the UK did, of course, immediately after the Brexit referendum. The third point that I would raise is the role of private laws
01:02:07
and private institutions. If you take FRS9, the president referred to it, this comes out of a purely private body. And accounting rules are, in fact, set by a private body.
01:02:26
This is being implemented now as a result of actions by the European authorities, but the rule itself comes out of private sector. If you look at derivatives markets,
01:02:45
the framework for deciding when a default event, when a credit event has occurred in CDS markets, for example, this is totally opaque. It's done by a committee of the International Securities and Derivatives Association that meets completely without
01:03:06
any public record and has been highly controversial. Is this acceptable? Is this legally appropriate? What's going on here? And then that goes into the bigger question
01:03:26
of what's the legal basis for dictating terms of private contracts and who can do that and what is proportionality and so forth. And finally, independence and accountability. I
01:03:41
tend to think of independence and accountability in the central bank framework as complements, not substitutes, not conflicting. That is to say that independence requires accountability, but accountability requires very clear goals. And that's one of the points about the central bank having an inflation target, say, which is a perfectly clear target. And either you miss it
01:04:06
or you don't. In the UK, if you miss it and you miss it too much, you've got to write a letter to the Chancellor of the Exchequer saying why you missed it. And that kind of accountability, it seems to me, is quite important. So I don't see there a conflict
01:04:23
between independence and accountability. They seem to me complementary, but maybe Kern would disagree with that. So those are a few ideas to throw on the table. And let me just see which of them the panelists want to pick up and start with Eric, if I may.
01:04:43
Well, yeah, there's a lot here. I don't think you want me to respond to all four. Can I pick one? I'll pick one. Let me make a few comments. You asked about the role of private law and
01:05:03
whether it's legally acceptable for this obscure committee to determine whether a credit event has occurred for the purpose of evaluating a credit default swap. At least under American law, that's fine. That's a private agreement. The broader concern here is whether these
01:05:22
decisions might have some kind of systemic effect. And there is no sort of private law approach to that problem. The only question is whether the central bank or some other regulator would be given the power to intervene in some way if it thought that one of these
01:05:41
decisions would produce some undesirable outcome. I think another example to throw on the table. Let me interject. The issue came up with some importance in the Greek case, when there was a lot of concern among the official sector that triggering the
01:06:01
CDS contracts would be destabilizing. So let's try to find some way out of this where Greece doesn't default but doesn't default. Right, right. I understand. And let me just add another good example, which is the LIBOR scandal. So LIBOR was basically a privately determined number, but because of the way it was used in the market, it had systemic effects.
01:06:28
And I guess the British government was put in an awkward position when the banks thought that maybe they should suppress their LIBOR submissions in order to address the credit crisis.
01:06:45
That example we could talk about all day. Let me just refer to one of your other points about regulatory cycles, and then maybe I'll let the other panelists decide what we should
01:07:00
talk about. But I do think that we're in a period of peak regulation, at least in the United States. And people have written often about this phenomenon, which is that regulation is a kind of lagging indicator. You get your financial crisis or downturn. There's a flurry of regulation afterwards, which of course is too late. And then the market
01:07:25
moves on to some other type of arbitrage. While these old regulations remain on the books, accumulating, interfering often with desirable behavior. So this is a view that's been out there for quite a long time. I tend to be a bit more sympathetic to the
01:07:43
regulators. If they don't try to stop the behavior that gave rise to the first financial crisis, then of course the market can go back and engage in that behavior all over again rather than arbitrage the way it does. So I just think the problem for regulators is that they have to constantly play catch up, but there is no avoiding that.
01:08:10
Thank you for these indeed very thought-provoking questions. Let me pick up on Eric's point because I can supplement this briefly. I think one of the things you have to think
01:08:21
about when you think about regulatory cycles is also the political sustainability. I don't know if we're at the peak of the regulatory cycle in the efficiency sense, however you think of it, or whether we're doing more than is useful. But it is clear that whatever it
01:08:42
is that we're doing may not be politically sustainable. And to me the question is then how do you design the institutional process to be more comfortable with the idea that you can actually sell optimal regulation to your political constituents? Because whether
01:09:11
we think we're peak trough or in the middle by some platonic standard, that actually may or may not have anything to do with reality on the ground. I also find the private
01:09:26
law question unbelievably important because we don't think of it in macroprudential terms usually. So first of all, to Eric's first point, that's exactly why I brought up the Gold Clause cases. There is a private response to some combination of law and economics. So
01:09:53
post-Civil War we start seeing these Gold Clauses everywhere. At a certain point that becomes macroeconomically unsustainable. In other words, even if I have a basement full
01:10:05
of gold and can pay off my debt in gold, all the contracts together can never pay back. And so in comes the public override in the form of legislative intervention, and then there's adjudication and then there's a really tortured set of opinions that say, okay. Now that's a kind
01:10:28
of a traditional, we can point to many examples of this private adaptation and public override. To me, the most interesting and fascinating example with ISDA is not the one you mentioned,
01:10:41
but the FSB turning to ISDA for help with the resolution protocol. So it is not just that there is this squirrelly private organization that starts out as a transatlantic body before we have international regulators, that develops the dispute resolution process before we catch on.
01:11:04
But at a certain point, governments realize that they can't accomplish what they need to accomplish through public law, right? Why do we go to ISDA for the resolution protocol? Because we know a treaty will take forever and will never happen. Whereas if they change their form behind closed doors in the basement, it'll happen overnight. There are two protocols in
01:11:25
two years, great. So really looking at this as much more of a public-private collaboration and identifying, you know, what about the people who write the Forex contracts? There are a billion of these standardized market-wide designs that are, and then another of course
01:11:42
relevant example is rating agencies, right? They will tell you they were private, but of course they were incorporated in a whole bunch of regulation, at which point it really didn't matter that they were private because they were public law. And now we say, well, no ratings, no way, no how. And then so what are we going to put in place and how are we going to incorporate private mechanisms? So market mechanisms. So I think the key point is that
01:12:06
if we think about a dynamic interaction between public intervention and private adaptation from the get-go, right, we may be less surprised and more sort of constructive or, you know,
01:12:21
at least more comfortable in this cooperation. And finally a very narrow point on the international dimension. So national level, we have hard law, statutes, regulations. International level, we have soft law, you know, Basel and every place elsewhere we meet
01:12:42
informally and take pictures, but there's no legal entity as such. The question I guess is, is that process becoming a political problem, an accountability problem? Do we need more formality? The fact that the FSB becomes a more formal institution, was that a good
01:13:05
preemptive move? I think this is a learning experience and I think what we're seeing is an evolution of how these questions are resolved. That said, you know, Volcker rule in European government debt, that was sort of decided the old-fashioned way with people visiting one another and, you know, behind closed doors. All excellent points. I'd say that
01:13:27
if we address the issue of conflicts between jurisdictions, we will always have conflicts between jurisdictions because of different institutional structures and different sizes of their markets and the structure of their markets as well. Some countries have bank-led
01:13:44
finance systems, some countries have capital market-led finance systems. And so capital adequacy requirements in the banking sector hit some economies harder than others. And so then that's why Europe is trying to develop a capital markets union now because continental Europe is heavily reliant on banks for sources of capital, whereas in the UK more,
01:14:04
you know, you get more reliance from capital market. So I think that countries are all affected differently from international standards of financial regulation and therefore that's why it's a soft law framework because countries want that domestic legal space to sort of say, okay, you've got this objective, these standards, these guidelines, we like to apply
01:14:23
them in our own local legal system. So I don't really think the answer is hard international law. I think it's really devising better standards that are more informed in trying to achieve efficient market objectives that can be clearly applied and implemented in different jurisdictions according to their own policy needs. And of course with reporting
01:14:44
responsibilities and transparency requirements regarding how countries report to how they're fulfilling these international standards. So there's pressure in international bodies like the IMF and World Bank can play a role in that area. They've done that before and have been criticized, of course, but still there is a role for international bodies.
01:15:01
The issue of the regulatory cycle, I think we may have hit the peak only because I read constantly about bank pushback now and the banks arguing that secular stagnation is caused because of heavy regulatory requirements and liquidity coverage ratio in Basel III
01:15:22
is too strict. So it sucks liquidity out of the market so banks can't trade between one another with liquid capital because they have to set that aside for the liquidity coverage ratio. We hear that capital requirements are too high and that there should not be a strict of a leverage limit. And so UBS Credit Suisse and Switzerland are constantly
01:15:43
lobbying the Swiss regulator now saying this 6.5 percent leverage limit that we have is just too high. It's hindering our ability to be a global bank and to manage our risk effectively. So the banks are pushed back. Politicians respond to that pushback.
01:16:02
People respond to that pushback. People want to borrow more. It's not just the banks. I say the banks are pushing back. Well, their customers want to borrow more. And so we have this cycle. The problem maybe is not the bankers. It's the people who elect the politicians. They want to borrow more. So we may possibly have hit that regulatory cycle. Trump might say we have with his views on the Basel Committee and some of
01:16:25
the Treasury report that came out recently. But yet I still think that there is more room for regulation to move, that banks should be raising more equity capital. It's a question of how much they should fund their lending and their business by issuing equity capital. The regulator is not saying they can't make the loans. It's just that they
01:16:43
have to fund more of their loans from equity capital. And there's nothing wrong with that, because we should have more investor financing of bank business. And banks should not be so highly leveraged the way they are. So I would say in the economic sense that would be the better approach. But the political pressure is still there
01:17:03
to limit any increase in further regulatory requirements. I think on the international issue, one thing I was reading in the FT today about the negotiations between U.S. and the EU on the equivalence regarding centralized clearing, about whether or not clearing houses in Europe would be able to clear derivative
01:17:22
contracts that are traded by U.S. banks. Right now that's not fully resolved, because there are some differences in the requirements regarding how clearing houses are regulated in both EU and U.S., but the goal is to have equivalence. So I think internationally the equivalence principle will develop further and that we will eventually, I'm
01:17:41
a bit more optimistic, think that we'll have nationally based regulation, but we'll have equivalence principles that will allow more enhanced market access. And then finally, I think Richard had mentioned the issue about central banks and the issue of – and regulators as well, the issue between independence and accountability. I think it's very important, of course, that central banks and regulators have independence
01:18:03
in the tools they use to achieve their objectives. But policymakers are ultimately democratically accountable, and policymakers ought to set those objectives. So in the U.K. we have a price stability mandate for the Bank of England. It's set by the Treasury, and the chancellor, the exchequer, and his minister set that.
01:18:25
And then they tell the Monetary Policy Committee, you guys are independent and using your instruments in achieving that 2 percent inflation objective that we at the Treasury have picked. And so we've got – in some jurisdictions I think the balance between independence and
01:18:40
accountability has been struck better than others. I would throw it out for discussion about whether or not – I think many of you know about, of course, the governing council of the ECB and the price stability objective in the Eurozone. The treaty says the ECB shall maintain price stability. But what is price stability? Who sets the 2 percent inflation target? 2.5 percent. I think the
01:19:03
ECB does. The governing council does, don't they? So now I might suggest that maybe policymakers might set that price stability objective of 2 percent inflation target. But the ECB would be independent in its instruments and how they use to achieve that objective. Policymakers might say a higher inflation
01:19:22
objective is more beneficial in the future, maybe 3 percent, 4 percent. But policymakers who are democratically accountable ought to be setting that objective, not democratically unelected central bankers. So – and this applies for regulation as well. So in IFRS, I think that is – it's okay to have the ISDA, the International Swaps
01:19:46
and Derivatives Association and the IFRS group, they – it's okay to have them setting standards and model contracts as long as regulators, when they accept them, they scrutinize them and put their scrutiny of these standards up for public discussion
01:20:01
and for public review. And so as long as, you know, the FSB is a – represents resolution authorities and they can opt in for certain privately set standards, but they should do so in a transparent way in which they are – the resolution authorities and policymakers are held accountable for what they do. And the issue of private contracts and public
01:20:22
law – public law intervention, I think that as economists you might think of the fact that many financial contracts generate substantial externalities, negative externalities. We saw this in the recent crisis. So the issue is should public law constrain the ability of private parties to enter into private financial contracts if the potential fallout
01:20:46
of those contracts is significant or possibly can lead to financial stability risk. I'm talking about, you know, the structured finance market, the securitization markets, the fact that investors will buy their – the wholesale debt markets or private contracts, and they
01:21:05
were lightly regulated before the crisis. To what extent should public law regulate and constrain the ability of lawyers to write those contracts that can potentially lead to systemic consequences if the risk in those contracts are not well managed?
01:21:22
Yeah, let me just push a little further on one point and then maybe another in a moment, but on independence and accountability. It's all very well to make the comparison with the central bank and who dictates the price stability target and so forth.
01:21:46
But with macro-prue, what are the goals? To what results are the macro-prue authorities accountable, right? What do they have to show at the end of the day, right, to
01:22:01
demonstrate that they're doing their job properly? I think that's a problem, no? Right, they have to show that a financial crisis didn't occur. But it's not that different from other types of regulation. The environmental agency
01:22:20
has to show that people were not poisoned by the discharge of chemicals into a river. So there's going to be, you know, there's going to have to be a certain level of trust, and if the trust is lost, then the government cannot do what it needs to do. I just want to also expand on something that Kern said, and this goes back to the
01:22:41
general issue of independence and accountability. You know, I think that's a lot more complicated than it sounds, because we'll take this macro-prudential question again. So what's the target here? So the target is financial stability. Well, what does that mean in practice? Well, aside from the ex ante regulation, there's also this problem
01:23:02
of what does the central bank do during the actual financial crisis. And here, you can see there are a huge number of choices that the central bank makes, and all of them turn out to be politically controversial. So in the United States, during the financial crisis, one of the choices the central bank made, and ultimately Treasury to some extent, but initially the central bank, was to, you know, help the Wall Street firms
01:23:25
and not to help the homeowners who were being kicked out of their houses. That turned out to be, you know, quite a consequential decision. Now, they argued that they made that decision because, as a technical matter, it's much easier to help the economy by channeling money to these large lending institutions. But a number of
01:23:45
economists and others have questioned whether that's really true. And it may well have been the case, the sort of populous, suspicious views, that they were helping their friends. You know, they were, in many cases, former Wall Street executives. And in any event,
01:24:02
they were talking to Wall Street. They weren't talking to the ordinary people. So the target, it turns out, can't just be financial stability. It has to be at some lower level of abstraction, you know, financial instability, but, you know, in such a way that helps ordinary people or homeowners more directly. But once you try to articulate
01:24:24
that target, you realize that, you know, before the crisis occurs, it's impossible to provide, you know, the level of specificity that would both be workable and would achieve consensus. So I think there's a real source of, you could call it regulatory instability,
01:24:42
and there's no real solution to it, as far as I can tell. Let me push back a little against Ana here. And on this, the private sector, the private law, if you like, and the acceptability. Suppose that you were to agree that calling
01:25:04
a default event, credit event in Greece, had significant potential for creating contagion effects and financial instability. Do you think that it's reasonable to have that decision lodged in and is the committee that meets in private and then comes out with a dictate?
01:25:28
Is that really appropriate? No, but that's not what happens, right? And in fact, actually, Greece was one in a long line of situations like this, the long-term credit bank in Japan. Remember,
01:25:44
they were going to put them under, but then they realized that there was an ambiguity in how ISDA contracts read under Japanese law that was going to have tremendous externality. So they basically asked ISDA for a no-action letter, to put out a letter that says this is how we determine the meaning. So to me, actually, a lot of the answers to these
01:26:05
questions is very bread and butter legal, which is process, right? So right now, we have a process, a public-private coordination process. The problem is nobody knows it. Not nobody, obviously, but it's not publicly accountable, so you have this situation where
01:26:22
not only does a private body at least appear to be making decisions, and in Greece, there was such magic to the way everything came out. But this was not an accident. They were talking to ISDA. They were talking to, this was surgically done not to trigger
01:26:44
the CDS. So the question is, do we want this process to be playing out in public? The answer may be yes, but I would love to hear a politician answer that question. How would you like to be seen as working out the terms of Greek default with the
01:27:02
International Swaps and Derivatives Association on TV? And I think that fundamentally is the challenge, right? So we can say, look, it's a public decision, but then— I'm going to be a pessimist again here. So here's the problem. These are private
01:27:22
contracts. The institutions that have made these contracts have obligations to make these determinations in good faith. If it turns out that the good faith determination would cause a financial crisis or a massive recession, they still have to do it. So here's what happens. The government comes in and says, please, please, don't do this. But
01:27:42
if they don't, they'd be breaking a contract and committing fraud against the private individuals who are counterparties to this contract. So in the case of LIBOR again, which I just happen to know about because I've worked on this, the banks, without being told by the government, or at least maybe
01:28:00
being told sotto voce, suppress their submission. And you could imagine this happening through agreement. Of course, if it had actually been through agreement, that's an antitrust violation. So you take their exposure, which is a trillion dollars or more, and you multiply it by three under American law.
01:28:20
So they would have to pay enormous amount of damages if they departed from the private contract, even for public-spirited reasons. Now, if the government commanded them to do this, not clear the government has the power, but if the government did, then at least if it were the U.S. government and were U.S. law, the government would be exposed
01:28:40
to that liability because the private actors would have their rights under the private contract, and they would be able to sue for damages. So the only solution I could see is that if you put into these private contracts at the time that they're negotiated some kind of clause allowing the government to intervene and override what the parties agreed to, but then the parties wouldn't put much
01:29:03
weight on the private contract because its value as a stable source of agreement would be contingent on the government acting in the right way. So, you know, I'm not sure there are any solutions here, but it's important to know what the problem is. There's a classic moral hazard issue underlying all that, too. But I think it's time now
01:29:25
to open the floor up for questions and comments, and I see hands going up all over the place.