Patterns in Financial Innovation and the improved adaptability of EU Financial Law.

 

 

 

 

 

 

 

We will examine the area of financial innovation and the legislative and regulatory system that is used to govern the financial industry in a two-tiered approach. The first tier examines (1) the nature of Financial Innovation itself, (2) the process and instances of its use in financial institutions, and (3) the influence of financial innovation in the creation of the asset bubbles (property and debt) that led to the two most significant market events in history; the 1929 Market Crash and the 2008 Financial Crisis. The second tier of research will focus on (4) a contextual overview of the global financial regulatory system, (5) the failure of global Financial Regulation in its apparent lack of development from 1929 to 2008, (6) the EU legislative improvements that have been made after 2008.

 

In the case of the governance of the Financial Industry, despite the categorical evidence of the positive impact of this industry on global economies over the course of the 20th century, the occurrence of two catastrophic economic crises in 1929 and 2008 nearly a century apart with very similar sets of circumstances being described as leading causes in both crises could lead one to infer that Financial governance has failed where other forms of governance or legislative mandate have succeeded in development in the same timeframe.

 

The evidence for the similarity in the causes of the 1929 crash and subsequent global depression and also the financial crisis of 2008 and the subsequent global recession is in the use of Financial Innovation to create the mechanisms and instruments that led to the creation of asset bubbles, the particular industries in which the bubbles were created and the prevalence of these asset bubbles in leading to both crashes. It is the lack of improvement of Financial Regulation’s ability to deal with this issue of financial innovation and asset bubbles over the course of nearly eight decades from the 1929 market crash to the 2008 crash that allows the basis for an assertion that the Financial Regulatory system failed during this period.

 

(1) The nature of Financial Innovation itself, (2) the process and instances of its use in financial institutions, and (3) the influence of financial innovation in the creation of the asset bubbles (property and debt) that led to the two most significant market events in history.

 

On the whole this failure on the part of Financial regulation could itself be said to be due to two main contributing factors; the individual nature of the financial industry and ineffective legislative methods used to create the industry's regulation. The uniqueness of the financial industry is in the everchanging nature and complexity of financial markets themselves as it could be said to be a living breathing thing in itself being a representation of the constant evolving collective organism of human production, events and behaviour. It is also unique in the industry’s production of novel groundbreaking complex methods of financing that circumnavigate previous financial laws through financial innovation or produce new territory that isn’t yet under legislation. This innovation can include generating new markets that stand alone or break off from pre-existing markets, developing new instruments or products that facilitate public or institutional investment or creating new channels that enable enhanced risk diversification (or appear to).

 

With regards to the 1929 market crash, the 1920s experienced a considerable growth in wealth and prosperity in the United States so much so that the decade was called the “roaring twenties”. This growth was fueled by a post war increase in industrialisation and the availability of new technology such as cars, radios or passenger planes improving efficiency and general quality of life. With a 340 point increase in the Dow Jones occurring over the decade, accompanied by this industrial expansion was the growth of the stock market. The financial returns that were produced by investing in the stocks of companies at the forefront of this industrial and technological surge brought new investors to Wall Street in their millions. In order to facilitate these new investors, financial intermediaries and stock brokers developed new financial instruments in order to enable as much investment as possible and to increase the variety or array of securities that could be invested in. Buying On Margin was a method for buying shares developed by brokers that enabled investors to purchase equity shares of companies provided the investor had compensated the broker a minimum percentile of the stocks full value. The broker would then sponsor the investor and loan them the remaining cost of purchasing the stock. This minimum percentile of the overall price that the investors had to provide to the brokers fell to as low as ten percent during the 1920s which enabled an exorbitant number of shares to be bought with loans that did not require any considerable guarantee. In order to fund investors buying on margin, the brokers themselves would seek “time loans” or “call loans” also using these loans to fund their “inventories of securities”. The value of broker loan debt extended to more than 8 Billion dollars by 1929, doubling from four to eight billion dollars from 1928 to 1929. The eight billion debt of broker loans was greater than the amount of currency rotating at that time, therefore when a market downturn in 1929 triggered uncertainty in the markets structure, banks and thus brokers sought further collateral on their loans to speculators or their lien on the shares would be forfeit. This dynamic significantly contributed towards the mass selling of securities that began in October of 1929 which began due to investors desire to severe their connection to faltering stocks and market uncertainty, however this selling only contributed to the market's downward trajectory and eventual crash. Rising share prices throughout the 1920s encouraged more people to invest hoping the share prices would rise further. Speculator investment thus fueled further rises and created an asset bubble. This stock market bubble was caused, as is any asset bubble, because the value of the assets connected to this market (in this case stocks) rose to very high levels due to the act of speculators buying them as opposed to any actual increase in the genuine tangible worth of the entities represented by or associated with the assets or in this case stocks.

 

Another form of Financial innovation that contributed towards the asset bubble that led to the 1929 Market crash was the securitisation of real estate bonds backed by actual properties to provide the construction industrys’ need for capital to fund its growth in activity during the 1920s. These bonds, known as Guaranteed Mortgage Participation Certificates, channeled cash flows from groups of properties, from a collection of different cities and towns, through an intermediary to groups of investors who had purchased the bonds on public capital markets. In order to facilitate the general economic and industrial growth after the first world war, there was an expansion in office building in mostly New York and Chicago and nationwide housing, with the idea of building commercial properties for as many tenants as possible in order to make financial gain. In a similar manner to the creation of a bubble in the general stock market, a real estate bubble was created by opportunist investors flocking to invest in what seemed like endless growth and profitability in the real estate market. However, what was an initial genuine need for new office property and housing turned into needless construction as investor participation fueled overbuilding. This overbuilding and lack of tenancies led to widespread defaults resulting in a rapid downturn in the real estate bond market. The rapid downturn began in 1928 was identified by two markers; a decrease in real estate bond yields in comparison to treasury bonds yields and with a decrease in actual issuance of real estate bonds which accounted for nearly a quarter of all corporate debt issuance in 1925 dropping to less than 1% by 1934. The downturn in the real estate market beginning in 1928 significantly contributed towards the lack of confidence in the overall stock market and therefore the ensuing 1929 Market Crash that followed.

 

Despite the early stage of maturation of the Financial Regulation System at the time of the 1929 Market Crash and the subsequent depression in the 1930s, its inadequacy to take these specific events into consideration and to take steps to prevent a very similar set of circumstances from occurring again can only be deemed as a dereliction of duty. The asset bubble that led to the financial crisis in 2008 contains similarities to the asset bubbles that led to the 1929 Market crash in that it was facilitated by innovative financial instruments or processes, it originated within the real estate market but soon spread to other markets and it contained a funneling of debt from one lender to another. The asset bubble in question was created by the use of Sub-Prime mortgages in the US which were mortgages offered to prospective property buyers that lowered the credit requirements that the buyers needed to qualify for acceptance of these loans. The Sub-Prime mortgages naturally attracted a considerable number of debtors, with these mortgages then being repackaged into Collaterised Debt Obligations (CDOs) and being sold to other financial institutions and investors. CDOs were a collection of loans and other assets that were packaged together and sold to institutional investors as derivatives but not before they were rated as potential investments by the major rating agencies viewed as viable investment authorities such as Standard and Poors or Moodys. Despite the lowered credit requirements contained within Sub Prime Mortgages and the clear default risk that the Sub Prime debtors posed, these rating agencies gave triple A ratings to the first tranches of the CDOs which contained Sub Prime mortgages. Critics of the rating agencies have commented that rating agencies did so due to fears that if they failed to rate the CDOs highly they would lose the repeat business of the Major Institutions that were selling the CDOs as investments. However, proponents of financial innovation and the rating agencies have reasoned that the higher ratings were given to the CDOs due to the purchase of Credit Default Swaps by the Institutions selling the CDO securities. Credit Default Swaps were effectively insurance against the default of the debt assets contained within the CDOs and were issued as derivatives by other major financial institutions and banks. The Sub Prime adjustable interest rates that were initially as low as one percent to attract mortgage debtors rose to as high as six or seven percent as the 2000s progressed, as the mortgage lenders believed that debtors would be able to rearrange their finance structure due to continuously rising property market. The real estate market however began to falter in 2006 which set in motion a financial events that would lead to mass default on sub-prime mortgages which in turn led to defaults of the CDOs and the failure of multiple financial institutions that had engaged with these derivatives such as Lehman Brothers or Washington Mutual Bank.

 

There is no denying that there are unquestionable similarities between both the innovative financial processes that led to the asset bubbles and the asset bubbles themselves that caused the near catastrophic market events and ensuing economic depression that took place in 1928 and 2008. Respectively recent innovative financial instruments and products lowered credit requirements for share purchase in the case of 1928 and property purchase in the case of the 2008 financial crisis. The funneling or channeling of debt (associated with these instruments) to other institutions spreading the risk of these instruments occurred in the run up to both 1929 and 2008. In both instances of market crashes, it could be suggested that these innovative financial products or instruments facilitated the creation of investment bubbles surrounding individual markets such as the real estate markets and the general stock markets, allowing estimated valuation and prestige forgoing any barometers or estimations of increase in genuine tangible worth.

 

(4) A contextual overview of the global financial regulatory system, (5) the failure of global Financial Regulation in its apparent lack of development from 1929 to 2008, (6) the EU legislative improvements that have been made after 2008.

 

Besides the individual and complicated structure of financial markets and innovation there are a number of significant reasons as to why legislative methods or approach are to blame for these market crashes. The reasons attributed to the legislative process would be overdeveloped specificity within legislation provisions as opposed to principles based legislation that could have systematically brought novel financial innovation under its scope, a lack in a constructive feedback process that allowed a swift reaction to financial events, such as the use of innovative financial instruments or products, that suggested a need for adaptation or supplementation to legislation in place. These reasons also include a lack of regulatory bodies, due to excessively stringent Acts, that could monitor and react quickly to potentially damaging financial activity that would have forced said legislative supplementation.

 

For the purposes of demonstration we will use the example of the EU financial regulation system before and after the 2008 financial crisis to demonstrate the key areas that Financial Regulation was lacking in its approach to financial innovation throughout the 20th century and impressive and calculated self-improvements and adjustments the EU has made after 2008. As previously mentioned, the central obstacle that prevented the EU regulation system from averting the US born causes of the financial crises that had spread to European financial institutions and organic EU financial problems was its inability to simultaneously achieve two targets of a harmonised application of EU financial rules throughout its member states and less prescriptive principles-based legislation that allowed for more flexible and adaptable regulation and rules. In 2001 a report known as the Lamfalussy Report was conducted into the functioning of the EU’s financial regulation system, specifically the Financial Services Action Plan (FSAP). Effective delegation and flexibility were identified as the two main deficiencies within EU Financial Regulation by this report with the overall structure of the system preventing adaptation to events such has financial innovation and swift reaction to complex and rapidly moving financial markets. The report set in motion the “Lamfalussy approach” which used a four-level structure, increased consultation to improve the standards of legislation and also used level 3 advisory committees to improve technical quality of the regulatory- process. However, as evidenced in the occurrence of the 2008 financial crisis, the Lamfalaussy approach failed in its endeavor to produce a more effective regulation system. According to Heikki Marjosola, implementation of the directives-led legislation depended on measures taken by national competent authorities, however these measures were often “delayed and divergent”. Implementation was also hampered due to the horizontality of the delegation structure, with member states maintaining little of the non-binding measures of the Committee of European Securities Regulators (CESR), which was responsible for bringing about convergence between member states. Another obstacle to the successful implementation of the Lamfalussy approach was that the principles-based legislation envisaged in the Lamfalussy Report came into conflict with the very detailed and therefore rigid legislation that arose as a result of the FSAP.

 

After the 2008 Financial Crisis, the Larosiere Committee was set up to arrange a comprehensive restructuring of the EU’s financial Legislative process, laws and regulatory structure. The Committee produced a report that issued thirty-one recommendations as to improvements that needed to be made. The responsibility of carrying out of these improvements was to be placed in the hands of the newly formed European System of Financial Supervision (ESFS) which consisted of the Europeans Supervisory Authorities (ESA’s), the European Systemic Risk Board and the national supervisory authorities of the EU member states. The overarching aim of this new system was to achieve optimum regulatory alignment between the member states and increase the flexibility of this area of EU Law utilising the ESA’s (ESMA, the EBA and the EIOPA) as independent legal authorities to achieve this alignment. In order to achieve these aims the ESA’s are responsible for generating binding technical standards which can be but also non-binding or “soft law” measures. The binding technical measures which the ESA’s can put into place include either delegated acts or implementing acts. Delegated Acts are formed when the EU Commision calls on the one of the ESA’s to develop technical consultation with regards to a defined issue and scope. These delegated acts however can also be formed when EU legislation provides a mandate for the ESA’s to produce technical standards which, being separate from any instigating mandate from the Commission, is therefore an example of the ESA’s acting more like independent legislative bodies as opposed to regulatory agencies. However, the Commission does have the power to amend or reject standards produce by the ESA’s and the representations of the standards must be made to the Commission before they are passed into law. It is in this ability of the ESA’s to generate binding measures in the form of Delegated Acts or Implementing Acts that we can see how the EU has learnt from the financial crisis and the need to allow flexibility and adaptability in its legislative process and how the EU through the newly established ESFS’s legislative abilities is more equipped to combat financial innovation.