In the deepening crisis in the global financial markets analysts have started to look for some of the causes – hopefully with the purpose to avoid them in the necessary restructuring of the markets. Let me point to three especially vicious phenomena which have contributed to this crisis.
1. The Bad
Stock options and bonuses for leading managers were originally intended to align managements’ interests with those of the shareholders. Agency theory had repeatedly pointed to the fact that managers could manipulate corporations’ results to their advantage because of their day-to-day superior (relative to shareholders) knowledge of what goes on in the firms. This gave them an advantage over shareholders who had to rely on management information. Thus, if managers received part of their remuneration in stocks (or options), they would have an incentive to run the company in a way which increased its stock value.
This led to short-termism (because of quarterly reporting requirements) and an incentive for managers to manipulate share valuations with the objective to maximize the value of their stock options, e.g. by making decisions and announcements driving up share prices on certain dates, buying back (and later reselling) the company’s shares, and others. Instead of increasing the long-term value of the company, short-term calculus took over. Boni – which were intended to reward and thus incentivize good performance – became an ever larger part of remuneration and reached obscene levels, both for top managers and traders, who were rewarded not for absolute performance in the medium and longer run, but again for share price developments at certain dates. Good intentions turned into imminent disaster, companies were bought and sold, not with a view to increasing their intrinsic value, but rather to drive up market valuations.
2. The Very Bad
Tax competition, reporting arbitrage, supervisory gaps and the general interest of managers to minimize their tax obligations, coupled with profit seekers in countries without many production and employment opportunities, led to registration and virtual location of firms in low-tax, low-reporting-requirement “offshore” centers, as well as the channelling of transactions, investments and funds to and through tax havens. Interestingly enough, many of these are located in former British colonies and territories. Today OECD names only 3 locations world-wide as “non-cooperative” regions, but has also a list of 35 locations which have recently been taken off that list, because they have legally instituted various forms of reporting and information requirements. These have satisfied the politically dominated OECD authorities of “upgrade” their status. Still, these locations channel large amounts of money away from the tax authorities of the countries where corporations and individuals actually do business.
This leads to a misalignment of funds, to regulatory arbitrage, to a lack of tax revenues in many countries. This is especially damaging for a number of emerging and developing countries which are desperately trying to raise significant tax revenues in order to be able to provide badly needed public services to their citizens. The practice of tax havens also exerts downward pressure on corporate income tax rates in all countries of the world, giving corporations leverage to negotiate favourable tax treatment also in so-called high-tax countries, or threats of locating away.
In addition to tax advantages, lower local reporting requirements and low levels of supervision attract funds from illegal and shady sources into such locations. The result is a lack of transparency of corporate behaviour, a high degree of money laundering, and lack of tax revenue. It needs to be recorded that during the last 10 years, efforts within the European Union to “dry out” such tax havens have repeatedly failed on account of severe opposition by – among others – the UK and Irish governments.
As the crisis evolves, it turns out that a large number of financial flows into these not or less regulated areas has obscured the regulatory powers in the official locations and has led to regulatory arbitrage.
3. The Ugly
During the last ten years regulation of the financial sector has undergone significant developments. On the one hand, ever new and complex financial instruments were being developed which led to ever increasing trading volumes of differently packaged securities; on the other hand investment banks doing this trading were outside the regulatory radar screen, as were hedge funds. Thus, once more, banks had incentives to move many of their assets and activities from their strictly supervised balance sheets into such non-regulated instruments and institutions. The volume of such activities multiplied over the last few years. In addition, national jealousy prevented – at least within the EU – the establishment of cross-country regulatory supervision. While the “Lamfalussy” process established an intricate network of responsibilities, reporting requirements and layers of supervisory authorities for EU member states, all these remain in national hands. This falls severely short of the supervisory needs caused by increasing cross-border assets and activities of large banks.
Today 80% of banking assets in Central and South Eastern Europe are owned by “Western” banks, but no joint regulatory supervision exists. While bilateral Memoranda of Understanding between the national banks and supervisory authorities exist, they refer at best to regulatory issues, but not to burden sharing for purposes or recapitalization or bank loan guarantees.
During the present crisis some voices have called for joint EU supervision of systemically important, cross-border banks and other financial institutions and all financial products, as a result of this regulatory failure. But so far, no politically serious attempt to this effect has started. Even if successful, this would still not go far enough, since also host countries outside the EU would have to be included into such an initiative.
When Sergio Leone in 1966 released the spaghetti Western “Il buono, il brutto et il cattivo” (The good, the bad and the ugly) with Clint Eastwood, Lee Van Cleef and Eli Wallach, he certainly did not have regulatory failure leading to financial catastrophe in mind. In this film, a sort of justice wins in the end – after a series of very bloody shootouts, mutilations and other atrocities. It is to be feared that the present financial crisis will also leave a number of economies very bloodied, with jobs and workers’ incomes as victims, and the reputation of many bankers and policymakers in tatters.
As one mosaic stone of a future financial system which reverts back to its original task of financing the real economy, the above regulatory failures need to be redressed. This is a necessary, but not a sufficient condition for a sustainable financial system.
From international data, serious estimates show that “spot” financial transactions today are around 8 times global GDP, but derivatives turnovers in 2007 were again 8 times that, i.e. more than 64 times world GDP. Radical reformers would say that this upper part of an inverse financing pyramid is economically unnecessary, even destabilizing and harmful. Its stupendous growth forms the core of the crisis. As such, it could be scratched from the face of the earth. The difficult truth, however, is that hedging instruments and insurance systems (part of this derivative trade) are necessary and important instruments for the functioning of the global economy, thus need to be maintained. To determine above which point these instruments turn into economic “bads” is an extremely difficult task. In addition, given the high political leverage which financial sector representatives have accumulated during this excessive growth period, they will resist any attempt by regulatory authorities and the state to outlaw, forbid or dis-incentivize these trades. To “cut them down to size” where they do make economic sense and not just benefit traders and top financial managers at the expense of the rest of the economy, as has happened in the recent past, will require a bloody battle. Strong leadership is necessary, if economic sense is to prevail.