Factors that Limit Regulatory Response in the Wake of the Global Financial Crisis: Ideology, Regulatory Capture, and Power Dynamics
Causes Within the Capitalist System
Ideological Adherence of Powerful Regulators to Market Fundamentalism that led to Minimal State Regulation
Market fundamentalism and its preaching of deregulation is indeed an ideology that Wall Street favors. Coincidentally, it was shared by powerful regulators on Main Street. For example, the belief that state intervention and taxation only distorts the market, and that rational actors can be relied upon to regulate themselves in a competitive environment of scarce resources was that of the Chairman of the Federal Reserve, Allan Greenspan (Greenspan, 2007).1
According to this logic, governments do not matter. If the world is as described by this neoclassical theory, then individuals are competent and capable of perceiving the world for what it truly is. They are able to act in a predictable way following the principle of utility maximization, and society as well following the principle of supply and demand. The market is therefore the best way to allocate resources in the most efficient manner, and financial capitalism can be most effectively realized if the market is free (Fama, 1970). Institutions such as the state and the bureaucracy are redundant and distort market equilibrium (North, 1995).
Regulatory actions reflected such ideological guidance. For example, Alan Greenspan tackled predatory lending in 2000 by forming a nine-agency task force that sought to investigate complaints from bureaucrats of predatory lenders. Much in line with the belief that individuals with complete information can make the best decision possible for themselves, Greenspan chose disclosure rather than action in spite of the task force’s recommendation that action be taken (McLean, Nocera, 2011).2 Individuals themselves were thought to be most capable of controlling their financial circumstances, and providing transparency in information that allows individuals to do so was the philosophical justification that Greenspan provided.
Phil Gramm, Chairman of the Senate Banking Committee, also shared the same ideology. He opposed any regulation against subprime lending because it would “subject those regulated to the abuses of arbitrary… governmental action” (McLean, Nocera, 2011). Moreover it was he who spearheaded the repeal of parts of the Glass-Steagall Act, which had regulated the finance industry and separated investment banks from commercial banks, as well as championed the Commodity Futures Modernization Act, which freed derivatives from government regulation. Therefore guided by the ideology of market fundamentalism, powerful regulators minimized the regulatory capacity of the state in finance.
Easy Access to Credit in the US due to Financial Globalization
Such ideology has also encouraged globalization. Globalization can be defined as the increasing integration of the world through transnational flows of goods and capital (Stallings, 2007). An element of market fundamentalism is economic liberalization, which is the necessary condition for globalization. After all, states need to remove protectionist policies and open up financial markets in order to be plugged into the world economy, and this assumes that states have embraced the market to some extent in the first place.
The ideology of financial liberalization was put to practice by multilateral institutions. The IMF, for example, encouraged developing nations to who needed loans to subscribe to the anti-statist prescriptions of structural adjustment programs (Harvey, 2007). It encouraged developing nations to attract foreign direct investment by improving confidence in their markets. That means reducing state intervention, tightening fiscal policies, reducing trade barriers and embracing the capital market. What is created is a global economy of close interconnection through trade and capital markets (Minsky, 1995).
In such global economy, the US is in a special position to attract capital. The size of the US market and the stability of US government makes it an appealing destination for investment. But also, its currency is easy to confide in. First, it is reliable as a medium of exchange because the depth and the liquidity of the US market makes it easily recyclable (Helleiner, 2008). Second, as a unit of account it is endorsed by international regulatory bodies who uses the dollar as the standard to set trade and exchange rules. Thus, it allows for easy and rule-bound business transactions (Cohen, 2003).
Third, it is stable as a store of value. For instance, the US Treasury Bill is backed by the government. Investors are assured that the value of their assets will be honoured (Norrlof, 2014). Leading up to the crisis, confidence in the US government also manifested into confidence in MBS, because mortgages in US issued by government issuers were implicitly backed by the government. Hence, in a global economic environment where the dollar is the top currency and the US is an attractive sight for investment due to its market size and government stability, it is indeed in a unique position to attract capital.
In fact, it has. Significant capital flown from other states to the US prior to the crisis. Much of it was required to fund the US trade deficit and was originated from the savings of East Asian and the Middle Eastern states (The Economist, 2012; Seabrooke, Tsingou, 2010). This flow of savings meant an expansion of capital, which became the easily accessible credit that US citizens used to finance and refinance mortgages.
Economic Volatility due to Excessive Fictitious Capital and Irrational Exuberance
In capitalism, periods of confidence in the market is bound to be accompanied by bubbles due to easy access to credit. Minsky, when examining the anatomy of a typical crisis, argued that changes in supply of credit are pro-cyclical and increased when the economy was booming (Kindleberger, Aliber, 2005). Easy access to credit fuel speculative boom in stock markets and in house markets, because of the confidence investors place in these markets for continuous growth. Feedback loops reinforce this notion and word of mouth attracts more investors to such an extent that speculation for capital gains leads to bubbles in these markets.
During this period, credit becomes detached from its monetary basis. When confidence in the market is strong, capitalists seek to expand their production capacities. But when cash reserves are dried up, credit must be used instead. The intense demand for credit that is accompanied by irrational exuberance results in a growing gap between credit and its monetary base, where growth of credit exceeds the growth of real measures of value, such as paper currency or a commodity of production. It becomes “fictitious capital” and it serves as a pool to be drawn on for further speculation (Harvey, 1982).
Seen from this lens, the financial crisis of 2007 was indeed a typical crisis. It was marked by a period of expansion in credit and a long-term housing bubble. As Shiller notes, the real home price for US between 1997 and 2004 increased 52 percent. This increase cannot be explained in terms of building costs, population, or interest rates. Speculation, feedback loops, irrational exuberance and easy access to credit offer more insight explanation instead (Shiller, 2005). Moreover, innovative derivatives were in essence fictitious capital that helped fuel the exuberance. Synesthetic CDOs, for example, were not based on actual commodities with values. They were based on CDOs, which were themselves contracted debt. Default in several subprime mortgages may render a tranche of CDO valueless, but the loss in value would be amplified through synthetic CDOs. Hence, markets in capitalism are volatile and have a tendency for exuberance and crashes. The 2007 crisis was not unique in this regard.
Therefore, there are two categories of causes of the crisis. The first category lies within the finance industry; the second category lies within a capitalist world economy where increasingly national economies are becoming interconnected. However, for orthodox economists, only the former is recognized (Walks, 2014). Orthodox economists, which are economists that dominate university economics departments, central banks, and financial sector adhere to various versions of market fundamentalism, or neoclassicism/neoliberalism, which limit their scope of analysis to firm-centric level that considers unregulated financial products, inflated CRA ratings, moral hazard problems, and regulatory capture to be distorting the equilibrium models that ultimately led to the crisis.
Ideology, expansion of credit, and irrational exuberance are neglected. For them, their regulatory response has been to recognize the limits of such level of analysis intellectually, and expand that to a sector based approach by defining the word “system” to mean the finance sector specifically and the important financial institutions within that sector. This, as I argue below, poses an intellectual constraint on macro-prudential regulation.
Factors that Limit Regulatory Reaction
Insufficient Recognition of Systemic Causes in Macro-Prudential Regulation (MPR)
After the crisis, the ideology of market fundamentalism has been undermined. The idea that the market is best regulated by itself as justified by efficient market hypothesis of the orthodox economist was what many academics and policy makers attributed to have led to the crisis. Thus, ideas with such orientation that dominated the international public sphere since the Reagan and Thatcher years were gradually replaced with a “Keynesian revivalism” (G20 2009; Giddens, 2010; Luckhurst, 2012). At its core, the revivalism challenges the feasibility of a self-regulating market and calls for government regulation.
Macro-prudential regulation reflects the Keynesian revivalism. MPR is defined by the Bank for International Settlements (BIS) as policy that promotes the safety and soundness of the broad financial system (BIS, 1986). It acknowledge the existence of systemic risks and acknowledges the Keynesian notion of a fallacy of composition: making one institution safe will not necessarily reduce systemic risk. Thus, it is the role of the regulators to implement policies that monitors the system as a whole, while staying alert for the spread of risk, the tendency for herding among banks, and the externalities that financial innovations create (Baker, 2013).
MPR was marginal prior to the crisis, but it gained grounds as the crisis unfolded. Powerful regulators such as Greenspan opposed MPR and regulators trained in orthodox economics saw little in it. But its presence particularly in the BIS paved the foundation for its emergence after the crisis. Individuals such as Claudio Borio and William White had established an inner circle of likeminded research economists prior to the crisis (Baker, 2013). The beginning of the crisis gave MPR legitimacy as they were able to flag correctly warning signs while undermining the legitimacy of market fundamentalism. Policy reactions of countries such as India and South Korea that followed the MPR principles to escape the worst of the crisis improved further its standing among regulators. Thus, it moved from a marginal intellectual realm into practice.
In addition to policy, the formation of new structures reflect the general acceptance of MPR as well. In the US, the Financial Stability Oversight Council seeks to monitor the stability of the nation’s financial system. In the UK, the Financial Policy Committee was set up within the Bank of England to identify sector related risks. At the EU level, the European Systemic Risk Board was established to produce recommendations in accordance to MPR principles, and the Financial Stability Board of the IMF seeks to do the same so at a global level.
But in spite of the acceptance it has gained, it is problematic for its ambiguous definition of systemic risk. There can be two scope for understanding systemic risk. In one scope, systemic risk mean risk within the finance sector in one state, and the interconnectedness of important financial institutions within a national jurisdiction constitute that system. For example, rather than measure the risk of one financial institution as would a micro-prudential regulator, measure the risk spread across financial institutions within Wall Street as intends the Financial Stability Oversight Council.
However this scope is problematic. One, in this scope system risk is confined by national boundaries when in fact many financial institutions are not bounded by such constraint. AIG FP, for example, had major operations in London. It was able to take advantage of regulator arbitrage leading up to the crisis, and spread risk abroad. Two, equally problematic is its assumption that financial institutions of systemic importance can be easily identified, when in fact circumstances can dictate the importance of a financial institution (Tobin, 1989). Thus, by implication, it is states that must regulate and it leaves little room for multilateral institutions to be influential.
Another scope for understanding systemic risk is to acknowledge the causes associated with financial capitalism. It is to see capitalism as the system that creates the condition for the spread of risk, and to account for the excess of credit as well as the irrational exuberance that finds an outlet in the market. Systemic risk is thus dynamic and borderless.
But theoretically, it is not clear how MPR understands systemic risk (Meszaros, 2013).3 It acknowledges the first scope of systemic risk, yet it shows the desire, through the formation of structures that transcend national boundaries such as the Financial Stability Board, to manage risk created as a consequence of a capitalist world economy. Hence, MRP is not theoretically comprehensive in its definition of systemic risk and it constrain
Regulatory Capture that Dilutes the Recognition of Systemic Risks
Theoretical limitation notwithstanding, MPR ideas has found its way into Basel III. Basel III’s main objective is to promote a “better balance between banking sector stability and sustainable credit growth” (Basel Committee on Banking Supervision [BCBS], 2010a). To do so, the Accord demands higher capital reserves, counter-cyclical buffers, new leverage ratios, and declares the intent to regulate systemically important financial institutions. (Dumiter, 2013). It adheres to MPR in the sense that regulators are explicitly given the duty of containing system-wide risks, and they are licensed to enforced prescribed policies to do so.
However, there are two kinds of limitations regarding Basel III. First, there are technical limitations with the new prescriptions. For example in terms of capital requirement, Basel III raised the capital reserve requirements of tier 1 capital, which is the core measure of a bank’s financial strength and accounts for common stock and reserves, to 8.5 percent (Vestergaard, Wade, 2012). But on average US banks hold around 10 percent, which means that this raise does not affect them. In fact, several scholars have recommended the increase to be 15 to 20 percent (Hanson, Kashyap and Stein 2010; Miles, Marcheggiano and Yang 2011). Hence, minimum capital requirement still remains low and this does not discourage risk-adverse behaviour from banks.
A reason such technical limitation exists is due to the inability of Basel III to withstand lobbying efforts with ideological adherence to market fundamentalism. Lall points out that the standards set by Basel III fail to be sufficient, because transnational lobby groups such as the Institute of International Finance (IIF) allow banks to dilute initial proposals. This was possible, because of the personal links that financial institutions had with the regulatory community (Lall, 2012). For example, Marc Saidenberg, who served as the Head of Regulatory Policy at Merrill Lynch and served as a member of the (IIF), was one of the members on the Basel Committee to formulate Basel III who cautioned against strong regulatory actions.
In fact, many of the IIF lobbyists were former heads of major banks who had close ties to the regulatory body (Callan, Wighton and Guha, 2007). Consequently, the policy prescriptions that Basel III sought to implement, such as capital requirements and leverage ratio, were diluted by lobbyists who are trained as orthodox economists and were able successfully undermine those elements.
The “club-model” of governance explains such regulatory capture. A club model of governance is where elite transnational financial regulators, international bank lobbyists, and financial institutional actors gather to shape the landscape of global finance. They share similar ideology and are confined to an exclusive network. This is problematic on two levels. First, they are largely unaccountable to the general public and may not share the same concern for the real economy as do elected politicians (Pak, 2013). But more importantly, it draws from a pool of narrow ideas that may not be radical enough for sufficient reform.
This was the case during the formulation of Basel III. Even though the Basel Committee on Banking Supervision broadened its membership geographically, these members were chosen through club channels rather than from a broader body of stake holders (Tsingou, 2014). The channel themselves are limited to the financial sector where powerful private interests were able to express themselves in an exclude and uncritical environment (Frieden, 2012). Thus, the Basel III process was club like and that made it more convenient for those sharing a similar ideology to dilute ambitions reforms targeted causes within the finance sector, but at the same time ignore systemic causes within a capitalist world economy.
Weak Coordination at G20 due to the Hegemonic Power of US
Ideological limitation and regulatory capture are not the only factor that limit regulatory agendas. Power between states matter as well, and this can best be demonstrated through the G20. Out of all the institutions that sought to realize MPR, G20 was thought by many to be the most substantial (Jones, 2010; Carin, Schoor, 2013; Blanchard, Ostry, 2012). First, the G20 consists of 20 states who accounts for 85 percent of the world economy (Organization for Economic Co-operation and Development, 2012).
With that coverage, it was thought to have the legitimacy to influence most of the world. Second, with the creation of the G20 leaders’ forum during the crisis, it was thought to have gained the capacity to combat the crisis where leaders could directly coordinate policies. Third, with a 1.1 trillion dollar support program, it was thought that that would support stimulus programs sufficient for macroeconomic programs to stabilize the world economy.
But in truth, the G20 played a much less substantial role. This is true for policy coordination. For example, in terms of coordination for stimulus program, Wade argues that almost all fiscal programs that were announced after the Washington summit had been decided prior to the summit, due to domestic pressure rather than coordination within the G20 (Wade, 2011). For another example, at the London summit the leaders committed to refrain from trade protectionism until the end of 2010 in order to avoid collapse of the world economy. However, by the Doha Round of negotiations, seventeen of the twenty broke that promise (Drezner, 2012). Thus, the capacity of the G20 to initiate and facilitate coordinated policy is put to doubt.
The trillion dollar rescue plan that was supposed to restore credit and growth also played a less substantial role. Out of the 1.1 trillion dollar the largest portion, 500 billion dollars, became funds made available to the IMF while the rest were divided for lending to less developed countries and to support trade finance. This fund boosted the IMF’s resource from 250 billion to 750 billion dollars, and gave IMF the capacity to create the Flexible Credit Line (FCL). But the fund was insignificant, because the concessional lending totaled only $3.8 billion by 2009 (Helleiner, 2014). In essence, the half of G20’s trillion dollar rescue plan that was mediated through the IMF could not play its role, because there were little demands.
There are three reasons that explain the low demand. First, countries such as South Korea were skeptical toward IMF loans, because IMF has a history of strict conditions on its loans that has a market fundamentalist orientation (Chey, 2012). Second, since the crisis has put to doubt the market fundamentalist policies that defined IMF, it entered a phase of incoherence and inconsistency in its policy strategies. It has, at times, reiterated pro-cyclical policy adjustment, while at the same time flirted with MPR (Grabel, 2011). The inconsistency in IMF’s strategy could not compete with a strong, coherent alternative, and that was the US as the lender of last resort.
The third reason that explains the low demand for IMF fund is the strong demand for US bilateral swaps. Bilateral swaps meant that central banks exchanged for dollars through their own currency with the promise to buy the currency back with interest. It was condition-free, and it provided dollar liquidity and access to the US market for domestic firms. Brazil, Mexico, Singapore, South Korean, European Central Bank, Swiss National Bank, Bank of England, Bank of Japan, Bank of Canada among many more all made such swaps. In effect, US was the lender of the last resort that created swaps that undermined the substantiality of G20’s IMF fund (McDowell, 2012).
When the South Korean government sought to reduce the dependence of the swaps on the goodwill of one country, it failed because of a lack of support by US. With a standardized cooperative mechanism for swaps, coordination and regulation could be institutionalized. But US was concerned that standardization would place burden on the Fed while concentrating the risk associated with moral hazard onto it as well. After all, the dollar was what the world demanded, and in the absence of conditionality it could encourage risky behaviours that burden US (Allen, Moessner, 2010). Hence, such standardized swap program did not come to fruition, as the US preferred short-term arrangements with states it selected.
In a multilateral institution where a hegemon can exercise significant power, its preference can easily prevail. Simmons, in her theorization of the politics of international regulatory harmonization, argues that if there is insignificant negative externalities for the hegemon, and high incentives for followers to emulate, there will be minimal role for multilateral institutions (Simmons, 2001). Such was the case for the swaps. Indeed, there were insignificant externalities for US. Bilateral swaps did not stretch US as it would had it commit to a standardized and regulated swap system. Conforming to standardization may in fact cost US resources. US moreover enjoyed first move advantage by exemplifying to the world how to add liquidity to the world economy, for swaps were then used between other countries. This exemplary role further diminished the demand by followers for a standardized swap system, and allowed the preference of US to prevail.
The preference of US for a weak international regulatory body is reflected by the toothless nature of the Financial Stability Board (FSB) as well. The FBS reports to the G20 and has the mandate of encouraging the implantation of international regulatory standards. It is toothless in the sense that it has no formal power through legal obligations, but compliance is rather enforced through peer review (Financial Stability Board, 2009). However, the peer review process has limits as a tool to promote international standards. For instance, peer review depends on the willingness of states to challenge their peers, but that has historically not been the case because treating another harshly will mean being treated harshly on the subsequent round of review (Verdier, 2013). Hence, FSB is a weak standard setter with no substantial mean of enforcing compliance.
Such was the preference by US. As the financial crisis effected the real economy, politicians were put under the pressure by the public to regulate finance. This was true in Europe as well as US, and it led to the politicization of the crisis (Gadinis, 2013; Quaglia, 2013; Soederberg, 2010; Tozzo, 2011). The US preferred a weak international regulator such that flexible policies could be instituted to appeal to domestic constituents. Adhering to international regulatory standards influenced by French and British ideas was also viewed by US politicians as unwelcomed. Indeed, Bush specifically wanted to avoid the impression that international group were strengthened at the expense of US sovereignty over its financial policy (Blustein, 2012). Thus, as Helleiner points out, no “fourth pillar” of global economic architecture came out of the weak FSB, and the preference of US to have it so was a significant cause (Helleiner, 2013).
By implication, the potential to addresses causes that lie within the capitalist system is further reduced. Given that the power of US in global governance matters significantly in shaping regulatory reactions, and given that the trend of countries including the US has been the politicization of regulatory measures with little interest in strengthening global regulatory bodies such as the FSB, the likeliness that systemic causes rooted in an increasingly interconnected and financialized world economy will be addressed is diminished. In the US, the politicization of regulation means that constituents matter much more than prior to the crisis (Tozzo, 2011). This leaves more room for lobbyists captured by market fundamentalist ideas who represent Wall Street to influence politicians and water down MPR and weaken global regulatory initiatives. The potential for regulatory capture has extended, and the prospect for status quo in terms of a weak international regulatory order has strengthened. Systemic risks inherent in capitalism are once again being neglected.Continued on Next Page »