Emilios Avgouleas

The Global Financial Crisis, Behavioural Finance and Financial Regulation: In Search of a New Orthodoxy

The global financial crisis brought the world banking system to the brink of collapse. The continuing operation of financial markets became possible only after the extensive and costly public rescues of some very big banks. It also brought into sharp focus the inadequacies of the contemporary model of financial regulation both at the national and the global level. This article argues that some of the measures endorsed in the G20 Summit for the revamping of national and global financial regulation, such as increased disclosure and a stronger capital base, and others targeting the enhancement of market discipline will prove less effective than anticipated. The reason for that is that they largely ignore the behavioural elements of the crisis. Instead, what is required is a radical rethinking of the contemporary model of national and global financial regulation. This article suggests a set of far-reaching reforms for the overhaul of the regulatory framework governing the licensing and supervision of banking institutions. It also proposes the establishment of a global licensing and supervisory regime for transnational investment funds with systemic importance, eliminating most shadow banking operators. The catastrophic consequences of the crisis and the findings of behavioural finance provide solid support for these proposals.

The Global Financial Crisis and the Disclosure Paradigm in European Financial Regulation: The Case for Reform

The global financial crisis has exposed the many limits of disclosure as an effective regulatory tool in financial markets. First, the famed disciplining power of the market failed to constrain disastrous risk taking by banks. Second, most of the risks that led to the creation of the 2008 catastrophe were often fully disclosed but the markets failed to understand them. In the case of banks, disclosure-based market discipline failed mainly because of the implicit government guarantee. In the case of capital markets, the reasons for disclosure’s failure were product complexity and the impact of socio-psychological factors. Yet much of European Financial Regulation is based on the disclosure paradigm to remedy market failure, discipline market actors, improve investor/consumer choice, and prevent abuse. The EU needs to re-examine the role of disclosure in two contexts: prudential regulation of banks and retail investor protection. EU policy-makers should use empirical and experimental studies before any reform of the investor protection framework. Insertion of default options in a variety of financial contracts may be a necessary supplement to disclosure for retail investors. Furthermore, an independent EU financial products committee would be a better regulatory protection strategy than reliance on investor choice assisted by enhanced disclosure.

Excessive Leverage and Bankers’ Pay: Governance and Financial Stability Costs of a Symbiotic Relationship

Debt has traditionally been viewed as an effective corporate governance tool. On the other hand, high leverage levels can lead to rapid expansion of the size of bank assets maximizing, in the short-to-medium term, banks return on equity. In the absence of regulatory controls on leverage, all it takes to assume excessive risks, even for benign bankers, is to imitate competitor business strategies. This form of herding can be motivated by compensation considerations or by career concerns. However, while bankers’ compensation has been a major factor behind bank short-termism, excessive leverage creates serious governance/agency costs even in the absence of compensation incentives. Therefore, a reasonably protective leverage ratio can prove an effective measure in containing rent seeking and smoothing up the leverage cycle to improve bank governance, prevent deep recessions, and safeguard financial stability.

The Eurozone Debt Crisis and the European Banking Union: A Cautionary Tale of Failure and Reform

The 2008 global financial crisis spread to most of the developed economies, including those of the European Union. Unfortunately, despite decades of effort to build a Single Financial Market, almost all EU jurisdictions lacked proper crisis resolution mechanisms, especially with respect to the cross-border dimensions of a global crisis. This led to a threat of widespread bank failures in EU countries and near collapse of their financial systems. Today, in the context of the Eurozone financial crisis, the EU is at a critical crossroads. It has to decide whether the road to recovery runs through closer integration of financial policies and of bank supervision and resolution, or whether to take the path of fragmentation with a gradual return to controlled forms of protectionism in the pursuit of narrow national interest, although the latter is bound to endanger the single market. Therefore, the policy dilemmas facing the EU and contemporary institution building within the Eurozone provide an important window into the future of both global and regional financial integration. The paper is in five parts. Following the present introduction, Part II provides an analytical overview of economic and institutional developments relating to the EU single market for financial services in the pre-crisis period. Part III discusses the evolution of the EU Single Financial Market and the causes of the Eurozone crisis. Part IV reviews the main tenets of the European Banking Union and considers how this new set of EU institutions will affect EU economic and political integration. Part V concludes with discussion of potential implications of EU experiences for the future of financial integration. ∗ Chair in International Banking Law and Finance, School of University of Edinburgh. Corresponding author. ∗ Professor and Head, Department of Law, University of Hong Kong. Corresponding author.

Rationales and Designs to Implement an Institutional Big Bang in the Governance of Global Finance

The colossal challenges facing international finance pertain to both its governance system and its dual utility and speculative functions, which have become ever more intertwined with the advent of financial innovation. In the aftermath of the Global Financial Crisis (GFC), a number of significant reforms are under way to address the second issue, including additional capital and liquidity requirements for banks, measures to battle interconnectedness in the financial sector, new resolution regimes that would allow banks to fail more easily, and stricter frameworks for bank supervision and monitoring of systemic risk. Yet limited progress has been made with respect to governance structures, which, thus, will be the main focus of present analysis. In this Article, I provide an outline of a proposal for a new model of governance for global financial markets to address most of the above challenges in a way that would be more effective than the preexisting regime or the architecture emerging as a result of the GFC.

International Financial Regulation, Access to Finance, Systemic Stability, and Development

Global financial markets are subject to a complex web of soft law rules and standards called International Financial Regulation. The main rationales/objectives of International Financial Regulation revolve around the protection of investors and depositors and the safeguarding of financial system stability. In recent months International Financial Regulation has come under attack for its lack of proper structures and flawed rules, which have been held to be among the main causes of the global credit crisis. As a result, a major reform exercise is under way. This paper argues that, as part of this reform, policy makers and regulators must attempt to widen the objectives of International Financial Regulation so that they become cognizant of the impact of financial sector development and access to finance on economic growth and poverty eradication. In this context, the paper proposes a global licensing scheme for international investment funds and the reform of the Basle Capital Adequacy Standards. Implementation of the proposals would enable International Financial Regulation to both strengthen the global financial stability framework and facilitate access to finance in poor and very poor countries.

Bank Leverage Ratios and Financial Stability: A Micro- and Macroprudential Perspective

Bank leverage ratios have made an impressive and largely unopposed return; they are mostly used alongside risk-weighted capital requirements. The reasons for this return are manifold, and they are not limited to the fact that bank equity levels in the wake of the global financial crisis (GFC) were exceptionally thin, necessitating a string of costly bailouts. A number of other factors have been equally important; these include, among others, the worlds revulsion with debt following the GFC and the eurozone crisis, and the universal acceptance of Hyman Minskys insights into the nature of the financial system and its role in the real economy. The best examples of the causal link between excessive debt, asset bubbles, and financial instability are the Spanish and Irish banking crises, which resulted from nothing more sophisticated than straightforward real estate loans. Bank leverage ratios are primarily seen as a microprudential measure that intends to increase bank resilience. Yet in todays environment of excessive liquidity due to very low interest rates and quantitative easing, bank leverage ratios should also be viewed as a key part of the macroprudential framework. In this context, this paper discusses the role of leverage ratios as both microprudential and macroprudential measures. As such, it explains the role of the leverage cycle in causing financial instability and sheds light on the impact of leverage restraints on good bank governance and allocative efficiency.

What Future for Disclosure as a Regulatory Technique? Lessons from the Global Financial Crisis and Beyond

Inadequate disclosure has been at the heart of most policy analysis of the global financial crisis. According to the inadequate disclosure critique, investors had insufficient information regarding the risks involved in structured securities, the flaws of credit ratings, and the impact of excessive executive compensation, all among the main causes of the recent financial market collapse. However, the global financial crisis has also exposed the many limits of disclosure as an effective regulatory tool in the context of financial markets. For instance, many of the risks that led to the creation of the 2008 catastrophe were often fully disclosed but the markets failed to understand what was disclosed and appreciate the implications. The reasons for this failure were product complexity and the impact of socio-psychological factors such as bounded rationality, strategic trade behaviour (herding), and cognitive biases. These findings pose a great challenge to the prevailing rational choice view of disclosure as a regulatory remedy of most market failures. At the same time, the issue of transparent financial markets dominates the global regulatory reform agenda. Accordingly, there is a clear need to devise strategies that make disclosure work under actual (not hypothetical) market conditions and redress the adverse impact of socio-psychological factors. The chapter argues that in specific contexts, such as the field of prudential regulation of banks, disclosure will only work if it is supplemented by protective regulation, e.g., business activity barriers and position limits. It also argues that only through the use of experiments, as a complement to empirical studies, policy-makers and regulators will be able to measure the actual contribution of disclosure to investor protection and devise effective disclosure strategies.

Three Major Financial Crises: What Have We Learned

Few experts predicted the Asian Financial Crisis of 1997-1998, or the Global Financial Crisis of 2008 and its close companion the Eurozone Debt Crisis of 2010, and we certainly do not pretend to be able to predict the next one. Yet history teaches there will be another crisis and probably sooner rather than later, and, of course, in the decade since the start of the Global Financial Crisis, the Eurozone crisis has been ongoing in many of its dimensions. Fragility that periodically erupts into a full blown financial crisis appears to be an integral feature of market-based financial systems in spite of the advent of sophisticated risk management tools and regulatory systems. If anything the increased frequency of modern crises since the collapse of the Bretton Woods international monetary system and the period of financial internationalization and globalization which has followed, underscores how difficult it is to prevent and deal with systemic risk. We thus seek to compare and contrast these three major crises both to distill the lessons to be learned, and to identify what more can be done to strengthen our financial systems. The following sections will provide an overview of each crisis in turn, considering in particular (i) its causes; (ii) the effectiveness of policy responses; and (iii) the lessons. In the conclusion we seek to draw some common themes from these experiences going forward.

Regional Financial Arrangements: Lessons from the Eurozone Crisis for East Asia

The growth of financial markets has clearly outpaced the development of financial market regulations. With growing complexity in the world of finance and the resultant higher frequency of financial crises, all eyes have shifted toward the current inadequacy of financial regulation. This book expertly examines what this episode means for Asia’s financial sector and its stability, and what the implications will be for the region’s financial regulation. By focusing on legal and institutional frameworks the book also elaborates on various issues and challenges in terms of how financial liberalization can maximize the benefits and minimize the risks of crisis.