Regulation and the Global Financial Crisis

Impact, Regulatory Responses, and Beyond

Daniel Cash, Robert Goddard, Daniel Cash, Robert Goddard

• Publisher: Routledge
• Year: 2020
• Print ISBN:
  9780367186197
• eBook ISBN:
  9780429576539
• Topic: Law
• Subtopic: Civil Law
• Index: Law

The Financial Crisis was a cross-sector crisis that fundamentally affected modern society. Regulation, as a concept, was both blamed for allowing the crisis to happen, but also tasked with developing and implementing solutions in the wake of the crash.

In this book, a number of specialists from a range of fields have contributed their insights into the effect of the Financial Crisis upon the regulatory frameworks affecting their fields, how regulators have responded to the Crisis, and then what this may mean for the future of regulation within those industries. These analyses are joined by a picture of past financial crises – which reveals interesting patterns – and then analyses of architectural regulatory models that were fundamentally affected by the Crisis. The book aims to allow sector specialists the freedom to share their insights so that, potentially, a broader picture can be identified.

Providing an interesting and thought-provoking account of this societally impactful era, this book will help the reader develop a more informed understanding of the potential future of financial regulation. The book will be of value to researchers, students, advanced level students, regulators, and policymakers.

Part 1
Structured response

1 Three major financial crises

What have we learned?^*

Ross P. Buckley, Emilios Avgouleas, and Douglas W. Arner

*This chapter was originally published by the Centre for International Governance Innovation (CIGI) in Douglas W Arner, Emilios Avgouleas, Danny Busch, and Steven L Schwarcz, Systemic Risk in the Financial Sector: Ten Years after the Great Crash (CIGI 2019). CIGI retains copyright of the Chapter. It is based in Waterloo, Ontario.

Introduction

Few experts predicted the Asian Financial Crisis (AFC), Global Financial Crisis (GFC) or Euro-zone debt crisis, and the authors of this chapter certainly do not pretend to be able to predict the next one. Yet history teaches that fragility, which periodically erupts into a full-blown financial crisis, is an integral feature of market-based financial systems in spite of the advent of sophisticated risk management tools and regulatory systems. If anything, the increased frequency of modern crises in the wake of financial globalisation underscores how difficult it is to deal with systemic risk. The authors thus seek to compare these three major crises to distill the lessons to be learned and identify how to strengthen global financial systems.

The AFC

In 1997–1998, Asia experienced its worst financial crisis of the twentieth century. It started with Thailand. Over a period of years, foreign money flooded into the Thai economy, fuelling a massive current account deficit combined with large-scale overborrowing from international markets and overlending.¹ Thailand was forced to allow its currency to float in July 1997, and the value of the baht plummeted as a result, highlighting huge mismatches between foreign currency borrowing and domestic currency sources of repayment.² Thailand’s crisis raised questions vis-à-vis the health of other emerging markets with similar features, and contagion soon spread to Malaysia, the Philippines, Indonesia, South Korea and eventually Russia, Brazil and the United States via the near collapse of the large hedge fund, Long-Term Capital Management.³

1Martin Feldstein, ‘A Self-Help Guide for Emerging Markets’ Foreign Affairs (March/April 1999) http://www.foreignaffairs.com/articles/1999-03-01/self-help-guide-emerging-markets; Peter Passell, ‘For a New Generation of Asian Tigers, a Harsh Currency Lesson’ The New York Times (24 July 1997).

2Ruse Arensman, ‘Economy Stall in Thailand has a Familiar Look’ The Denver Post (2 November 1997).

3Paul Blustein, ‘Investors Reconsider Big Emerging-Markets Bets’ The Washington Post (20 July 1997); ‘IMF happy with Malaysia, But Says There is Room for Improvement’ The Australian (29 April 1998).

An overview of the AFC

The AFC was not a conventional sovereign debt crisis. The indebtedness was that of the private sector, not the public or quasi-public sector, and it occurred within ‘a benign international environment with low interest rates and solid growth in output and exports’.⁴ Initially, this was a series of currency crises that developed into more generalised financial and economic crises, at least for Indonesia, Thailand and South Korea, the three most severely affected countries. Currency devaluation made foreign currency debt repayments funded from domestic lending unmanageable, resulting in nationalisation of financial sector liabilities in order to stem the resulting systemic financial crisis. Affected countries then found themselves facing unsustainable sovereign debt levels, which in turn required assistance from the International Monetary Fund (IMF) and others.

4World Bank, Global Development Finance, vol 1 (Washington, DC: World Bank 1998) 30 [World Bank 1998] http://documents.worldbank.org/curated/en/917631468138290229/pdf/multi-page.pdf.

Causes of the AFC

The four principal causes of the AFC were: the type and extent of indebtedness; financial sector weaknesses; fixed local exchange rates; and a region-wide loss of confidence, which eventually spread to emerging market economies worldwide.

Short-term indebtedness increased significantly in 1995–1996 across the region.⁵ The ratio of short-term to total debt in mid-1997 ranged from 67 percent in Korea to 46 percent in Thailand and 19 percent in the Philippines.⁶

5World Bank, Global Development Finance, vol 1 (Washington, DC: World Bank 1997) 16 http://documents.worldbank.org/curated/en/978911468163455868/pdf/multi-page.pdf.

6ibid. 35.

The primary problem with foreign investment in emerging markets’ short-term debt is non-commitment.⁷ Outflows may trigger a collapse in investor confidence. Volatility heightens when short-term debt is denominated in local currency, since a substantial devaluation will decimate a local currency portfolio.

7Alain Soulard, ‘The Role of Multilateral Financial Institutions in Bringing Developing Companies to U.S. Markets’ (1994) 17 Fordham International Law Journal 5, 145, 147.

The extent of indebtedness in East Asia was the product, in part, of excess liquidity in the developed world in the two years prior to June 1997. East Asian stocks and bonds were acquired by US and European investors who had grown wary of low interest rates and feared that US stock markets had reached unsustainable heights.⁸

8Blustein (n 3).

Financial sector weaknesses: failure to intermediate capital flows effectively

Capital inflows often ended up in speculative property and stock market investments that could not generate the foreign currency reserves needed to repay foreign currency debt.⁹

9Shigemitsu Sugisaki, ‘Economic Crises in Asia’ (Address delivered at the 1998 Harvard Asia Business Conference, Boston, 30 January 1998) http://www.imf.org/en/News/Articles/2015/09/28/04/53/sp013098.

Local banks borrowed short and lent long, mostly without hedging their foreign exchange exposures. Regulatory standards were inadequate.¹⁰ Domestic banks were often controlled by people connected to the ruling political party, and their conduct was influenced by the prospect of a bailout. Indiscriminate international borrowing and domestic lending meant that when the bubble burst, banks in Indonesia, South Korea and Thailand were in crisis.¹¹

10World Bank (n 4) 4.

11Rudi Dornbusch, ‘A Bail-out Won’t Do the Trick in Korea’ Business Week (8 December 1997); Robert Garran, ‘Korea Crisis’ The Australian (19 November 1997).

Premature liberalisation of domestic financial markets

Foreign money had flooded into Thailand directly through institutional investors’ portfolios in local stocks and bonds, and indirectly as Thai banks borrowed heavily from their foreign counterparts.¹² All three countries had opened their financial systems to international capital flows without reinforcing domestic stability.¹³

12H Chow, ‘Crawling from the Wreckage’ (1997) 4 Emerging Markets Investor 15.

13IMF, World Economic Outlook (Washington, DC: IMF 1998) 6 http://www.imf.org/en/Publications/WEO/Issues/2016/12/31/Financial-Crises-Causes-and-Indicators.

Fixed exchange rates

Prior to the AFC, fixed exchange rates appealed to developing countries because they appeared to offer lower credit costs¹⁴ and inflation rates, and discipline against government monetary or fiscal excesses.¹⁵ However, when an economy with a fixed exchange rate is performing less strongly than the economy to whose currency its currency is fixed, adjustment is required. Otherwise, the fixed currency will become overvalued, as occurred in Mexico in 1993–1994, Thailand and Indonesia in 1996–1997, Russia in 1997–1998 and Argentina in 2000–2001.¹⁶

14I Viscio, ‘The Recent Experience with Capital Flows to Emerging Market Economies’ (1998) 65 OECD Economy Outlook 177; Pablo Bustelo, Clara Garcia, and Iliana Olivié, Global and Domestic Factors of Financial Crises in Emerging Economies: Lessons from the East A...

Table of contents

• Cover
• Half Title
• Series
• Title
• Copyright
• Contents
• List of contributors
• Introduction
• Part 1 Structured response
• Part 2 Tales from the marketplace
• Index