Shadow banking system that escaped regulation, faith
in ´wisdom´ of markets led to meltdown, study says

Press Release
For use of information media - Not an official record
Shadow banking system that escaped regulation, faith in ´wisdom´ of markets led to meltdown, study says

Geneva, Switzerland, 19 March 2009

Financial boom-and-bust cycles need to be regulated, UNCTAD contends, and "casino" economies should not be allowed outside normal banking sector

The contents of this press release and the related Report must not be quoted or
summarized in the print, broadcast or electronic
media before 19 March 2009, 17:00 GMT
(18:00 Geneva)

Geneva, 19 March 2009 - A sustained process of financial de-regulation -- within countries and between countries -- led to an expanding cycle of optimism and risk-taking that is at the root of the current global crisis, a new UNCTAD report says.

The authors of the report The Global Economic Crisis: Systemic Failures and Multilateral Remedies (1) point out that history indicates that financial systems are intrinsically unstable and prone to boom and bust cycles, and need to be regulated. However, modern financial regulation is based on the assumption that "markets know best" and does not take sufficient account of the regularly repeated lesson that financial markets can fail. For example, the report says, current economic indicators of risk tend to show low risk at the peak of the credit cycle, exactly when risk is high.

The report, released today, was written by the economists of UNCTAD´s Secretariat Task Force on Systemic Issues and Economic Cooperation in advance of several upcoming international conferences on the global economic crisis.

Strongly needed reforms to national and international financial systems should be carefully designed so that they aren´t limited to specific investment instruments, the study recommends. New instruments can always be created that get around the rules.

Instead, regulations should focus on controlling the "mechanism" that leads to crises. The mechanism entails a wave of optimism, which leads to a willingness among investors to take greater risks, which leads to the assumption of greater leverage. . . which then leads to higher asset prices feeding back into more optimism, leverage, and eventually inflated asset prices.

Recent United States banking regulations, for example, were designed to control risk through the measured capital ratio used by commercial banks, the report says. This attempt backfired because bank managers circumvented the rules either by hiding risk or by moving some leverage outside the banks. This shift in leverage created a "shadow banking system" which replicated the maturity transformation role of banks while escaping normal bank regulation. At its peak, the US shadow banking system held assets of approximately $16 trillion, about $4 trillion more than regulated deposit-taking banks. While the regulation focused on banks, it was the collapse of the shadow banking system which kick-started the crisis.

As reforms to the financial system begin, an early task of regulators should be to weed out financial instruments which only increase risk without providing any true social return, the report recommends. For example, credit default swaps (CDS) can provide a useful hedging service, but the use this instrument has far outgrown that role. Current CDS investment is ten times larger than what is needed to provide a true hedging service -- a difference of about US$13 trillion.

Financial market instruments that do not contribute to long-term economic growth or reduce the volatility of household consumption do not provide any true social return. Several financial instruments that played a role in the current crisis generated high private returns -- for a while -- but had no social utility whatsoever, the study contends. In effect, they were little more than gambling instruments, a "casino" that was superimposed upon the real economy and whose only business was wagering on uncertain outcomes in the real economy.

In the United States, policymakers and regulators should have been suspicious of a financial industry that constantly aimed at double-digit returns in an economy that naturally grew at a much slower rate. The US financial sector expanded from generating 5% of the nation´s GDP and accounting for 7.5% of total corporate profits in 1983 to producing 8% of GDP and accounting for 40% of total corporate profits in 2007. There is little indication that this increased income contributed to lasting economic growth or social welfare, the study says.

In the wake of crisis, there is widespread political support for greater regulation, the report notes. But often, after a period of economic stability is achieved, policymakers lose sight of the rationale for existing regulations and begin to scale back. A possible solution to this self-defeating cycle is to follow the example of air-safety regulators, who, besides learning from relatively rare airplane crashes, also put a great deal of attention on near misses, the study says. In the field of financial regulation, there was much to be learned from the collapse of US-based Long Term Capital Management (LTCM) in 1998 -- but because a crisis didn´t result, systemic changes were not made. A proper regulatory response then might have limited the consequences of the current crisis.

Regulatory "arbitrage," to be effective, must have an international dimension to complement national regulations. Regulators around the world should communicate and share information, should set standards, and should avoid "races to the bottom" in financial regulation in attempts to attract investment funds. However, the study adds, it would be a mistake to impose uniform regulatory standards: there is no single regulatory system which is right for all countries.