Saule Omarova
Complex financial instruments increase systemic risks and jack up leverage in the financial system. The International Monetary Fund (IMF) wants regulators to be prepared to identify systemically important financial instruments (Global Financial Stability Report, p.20). Yet, even transparency is impossible as long as financial instruments are overly complex, argues Suleika Reiners of the World Future Council. Financial regulation and supervision lack always behind because a key driver of new financial instruments is the desire to overcome regulation and avoid taxes, she says.
For these reasons, the World Future Council and the EU Office of the Friedrich-Ebert-Stiftung have organised an international workshop on a mandatory approval of financial instruments (Brussels, 22-23 September). The approach is to build on the concept of regulatory precaution borrowed from the environmental and health law: financial instruments should be put to the precautionary principle no less than other aspects of society such as chemicals and drugs.
The workshop brings together leading academics such as Saule T. Omarova (Professor of Law at the Cornell Law School in New York) with financial policy makers such as Peter Simon (Member of the European Parliament for the Social Democratic Party of Germany, Vice-Chair Committee on Economic and Monetary Affairs). Ahead of the event, both agreed to answer some of our questions.
Omarova: This is one of the central questions in designing a product approval scheme, and there are potentially different ways to approach it. In general, such a regime should target only those types of financial products that increase the levels of complexity, opacity, leverage, and potential instability in the financial system. Inherently, this regime is broad in its regulatory scope and systemic in its focus. For instance, it is possible to mandate pre-approval for all classes of complex financial instruments and activities and then create specific exceptions for instruments that are less likely to pose significant systemic stability risks. In the alternative, the legislation may enumerate certain classes of financial instruments and transactions that pose potentially high systemic risk and, therefore, are subject to the mandatory pre-approval regime, and then grant the regulators discretionary authority to expand that initial list by adding new classes of potentially risky instruments and transactions.
Both of these approaches would target derivatives, asset-backed instruments and structured products. Traditional, simple financial instruments that facilitate savings, investment and capital-raising – such as, for example, ordinary bank deposits or issuances of shares by companies – should be generally exempted from the mandatory approval regime.
What is the distinction between a new financial instrument and the adaption of an existing one?
Omarova: Developing specific criteria for determining when a previously approved financial product has been altered or adapted to such a degree that it should be treated as a new product subject to separate approval is a challenging exercise. Inevitably, it requires a flexible, individually tailored review and ongoing monitoring of each financial product’s post-approval life. Regulators would have to track changes in the key terms of the approved product, which may include terms related to payments and other material rights and obligations of the parties to the transaction, the nature of reference assets, the intended and actual uses of the product, the nature and systemic footprint of the counterparties and target markets, etc. Accordingly, financial institutions would be obligated to provide and continuously update the relevant information to regulators.
Importantly, private firms would be primarily responsible for determining at which point the overall risk profile and potential systemic effects of their existing product or trading or investment strategy changed enough to warrant a new approval application. The consequences to a financial institution of failing to apply for a separate approval of a financial product, which is being used for a different purpose or by a different class of clients than originally disclosed to the regulators, would be severe: any transactions in such new, unapproved instruments are illegal. Among other things, this should create a strong incentive for financial institutions to monitor their own activities much more closely, and with an eye toward their systemic significance.
Which decisions are to be taken at the global level, and which can be left to national or regional administrations?
Omarova: Ultimately, in today’s globalised financial world, any regulatory regime controlling or limiting financial institutions’ ability to maximise their profits creates competitive pressures and potential for cross-border arbitrage. As a practical matter, instituting an effective domestic scheme of mandatory product approval would require, at the very least, agreement on the principles and cooperation among financial regulators overseeing the most advanced and active capital markets. To reap the greatest systemic risk-prevention benefits of this regime, at least the key financial-market jurisdiction would have to agree on, and commit to implementing, the fundamental principles and goals of product approval regulation. Whether or not a specific decision should be made on a supra-national, rather than a national, level would likely depend on the nature of the financial product at issue, the degree of cross-border inter-connectedness in the market for that product, and the individual financial institution seeking approval.
How can the fear of regulators and supervisors to be liable for their decisions be dealt with?
Omarova: It depends on how the enabling legislation is drafted. Regulators and supervisors should not fear that, by simply doing their jobs, they expose themselves to liability or political backlash. Frequently, that fear is there because of the regulated industry pressuring or threatening regulators. Such threats are often implicit, as in the case of financial institutions’ “prediction” of some calamitous events in response to regulatory action they oppose. Industry resistance to regulation is especially powerful if the law proclaims several potentially conflicting policy objectives such regulation aims to achieve, thus providing at least a superficially legitimate basis for self-interested parties to contest regulators’ judgment.
By contrast, a statute that unequivocally states its primary goal of reducing complexity and systemic risk in the financial marketplace would empower the regulators facing socially harmful resistance from private actors. At the same time, the statute would have to establish clear procedures for contesting individual decisions to deny or revoke approval of a particular product, in order to ensure the necessary levels of transparency and accountability of regulators. Thus, the key task in this respect is to combine a strong regulatory mandate with a robust administrative process.
What would be the benefit for regulators and financial supervisors?
Omarova: From a viewpoint of financial regulators and supervisors, the main benefit of product approval regulation is that it explicitly and unapologetically shifts the fundamental presumptions in favor of pro-actively regulating private market activities that potentially render financial systems less stable and less manageable.
As a burden-shifting device, product approval regulation cures the informational asymmetry between private firms and their regulators. If implemented properly, this regime should ensure that regulators and supervisors continuously have their fingers on the pulse of the financial markets they oversee. More generally, to the extent this scheme leads to controlled reduction in the volume and sheer complexity of financial transactions, it should help to restore the critically important balance between our regulatory needs and our regulatory capacity.
In its European election programme, your party calls for a finance TÜV. Why has this been given a priority?
Simon: The recent financial crisis has unveiled the deep-rooted illness in the global financial system. Moreover, it deprived many citizens of their savings, which they had invested into financial instruments they had not properly understood and whose hidden risks have made a major contribution to the current situation we find ourselves in. For these reasons, improving the quality and unveiling the risks of financial instruments is an integral part of consumer protection, which in turn is one of our many objectives for the current legislative term – a Europe for the people, not for the banks.
What are your next steps to take this policy proposal forward?
Simon: The seal of approval of an independent organisation which states, for example, that an investment product is actually suitable to retail clients, would certainly be more than welcome. At the moment there are still quite a few questions that need answers before we can go ahead. Who could perform those tests? What happens if the evaluation was actually not accurate? Who will be held liable? These are just some of them. A lot of practicalities need to be discussed. I therefore very much welcome this international workshop to discuss a (mandatory) approval of financial instruments.
What political opportunities do you see for a finance TÜV?
Simon: The European agenda for the next few years has not been fully shaped yet. Hence, now is the time to bring forward new ideas. We need to move to a more intense discussion on the topic and find answers to all outstanding questions, both in academic as well as political circles.
The interviews were conducted by Suleika Reiners (World Future Council).
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Saule T. Omarova is Professor of Law at Cornell University Law School. Peter Simon is a German MEP and Vice-Chair of the Committee on Economic and Monetary Affairs.