Trichet: Shift in the paradigm of finance that can do more harm than good
07 May 2010
If banks neglect their primary activity of due diligence, and if they come to abuse risk control techniques, liquidity creation and arbitrage opportunities, finance will do more harm than good to the economy, Trichet said. The enforcement of transparency in financial structures is essential.
He emphasized that finance turned into a source of instability and economic regress when screening and monitoring services are neglected, and when risk management, liquidity transformation and price discovery are flawed. There is unlikely to be a better case study of the functional degradation of finance than the events that led up to the crisis that started in 2007. He is convinced that if banks neglect their primary activity of due diligence, and if they come to abuse risk control techniques, liquidity creation and arbitrage opportunities, finance will do more harm than good to the economy. And crises of the magnitude that we have witnessed become unavoidable.
This is not to say that financial markets are solely to blame for the financial crisis. Policy-makers, regulators and supervisors also bear some responsibility for the incidents that led to the most severe financial crisis since the Great Depression. But understanding the impact of the paradigm shift of private finance in recent years demands a deep introspection into the inner mechanisms of financial economics.
He presented three elements at the core of efforts to reform the international financial system:
· The first is a mechanism that enforces transparency in financial structures. This is essential for the financial industry to return to its prime mission of assessing the quality of investment. The trend towards more sophisticated financial instruments has not been matched by increasing disclosure requirements. Sellers of securitised products must disclose all information about the underlying loan structure so that both investors and rating agencies can correctly price the risks embedded in these products. More transparency can also be achieved by central counterparty clearing of bilateral over-the-counter trading arrangements.
· Second, the progressive mutation of arbitrage into speculation needs to be reversed. Financial players that take large speculative positions in certain segments of the market can exert a non-negligible bearing on the future pricing of an asset or bond by affecting market sentiment. Current market structures can aggravate this effect. For instance, investors are currently allowed to buy credit defaults swaps without holding the underlying asset, typically a bond. By first buying the credit default swaps and then trying to affect market sentiment by going short on the underlying bond, investors can make large profits without a change in the fundamental value of the reference entity and, worse, to its detriment.
· Third, credit and liquidity risk management should not become a force of pro-cyclicality for the financial system as a whole. Limited liability in economic contracts introduces an asymmetry that is potentially fatal in the financial sphere. Owners and managers of financial companies are given a distinct incentive to expand risk-taking in anticipation of high returns (if there is a favourable pay-off), while remaining confident of a limited loss in the event of failure. The perception that public authorities will always socialise the costs of financial crisis reinforces private investors’ expectation that they will harvest more of the upside and shift more of the downside. Regulation should attempt to limit the risks banks assume by imposing higher, countercyclical capital requirements, thus limiting leverage. Financial institutions will be asked to raise the quality and quantity of their capital base to ensure they have adequate funding in place as a buffer against future market disruptions. A correction of compensation practices for financial employees is also warranted. Compensation should put emphasis on rewarding longer-term business performance. These objectives are currently examined within the framework of the Basel Committee on Banking Supervision.
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