World financial system not as reformed as we think

One of the more unusual traits shared by George Bush and Bertie Ahern was their tendency for malapropisms.

With ‘Bertie-speak’ we always had the impression that they were semi-deliberate.

However, in George Bush’s case, they seemed to come straight from the heart.

One of my favourites was: “Fool me once, shame on, shame on you. Fool me, you can’t get fooled again,” if for no other reason than you can’t help but be surprised that someone like George Bush had lyrics from The Who embedded somewhere in the recesses of his mind.

The Bush administration collects the blame for its laissez-faire attitude to financial markets, even though it was the Clinton administration that repealed the Glass Steagal Act.

This allowed the expansion of derivatives in main street financial institutions, often described as the root cause of the 2008 financial crash.

In a similar vein, the Obama administration is widely credited with saving the banks and reforming the financial system.

However, the world’s financial system may not be as reformed as we have been led to believe.

One of the main deficiencies exposed by the 2008 crash was that financial regulators were not aware of the extent of derivative exposures, particularly the degree to which those exposures were interconnected across financial institutions around the world.

At an early stage, it was identified that having a handle on the overall level of risk in derivative exposures was important.

In 2009, the G20 set out a series of derivative market reforms designed to mitigate systemic risk, improve transparency and protect against market abuse.

A total of 21 recommendations were made and the Financial Stability Board (FSB) was tasked with monitoring progress.

This summer, the FSB published a report on implementation of the reforms and it makes for some concerning reading.

Progress could, at best, be described as patchy.

For example, the report notes that few jurisdictions have regulatory frameworks in place to promote execution of standardised contracts on organised trading platforms, as recommended, and most jurisdictions are only in the early phases of implementing the framework for margin requirements for non-centrally cleared derivatives.

You would have imagined that, some seven years after the crash, all of these reforms would have been implemented and regulators would have a comprehensive mechanism for assessing up-to-date exposures and vulnerabilities to derivatives.

To be fair, some progress has been made in that some national regulators require that derivative trades are reported to special repositories.

However, this system is like a bucket with a hole in the bottom.

Many of the special repositories have different rules, keep data in different formats and do not share data.

It reminds you of the Irish regulator’s lack of a comprehensive view on credit exposures in the Irish banks and we all know, to our cost, how that can end.

Perhaps most concerning is the fact that many new types of customised derivative contracts have been developed over the last few years that are not traded on exchanges and, consequently, are not well understood.

It is estimated that the actual level of derivative exposure is at a higher level now than before 2008 and just as opaque.

These exposures may remain unremarkable in periods of low interest rates with low volatility, as we have experienced over the last few years.

However, if the latest stock market slide in China presages a spike in volatility, the result may lead to margin calls revealing losses with the potential for contagion, particularly in relation to some of those new customised derivative contracts.

It is to be welcomed that the authorities, at least, recognise the problem, unlike the situation in 2008, and have started a review that will report on barriers to sharing derivatives data at the summit of the Group of 20 nations in November.

However, these are not routine or run-of-the-mill issues and one would have expected that some more urgency would have been exhibited to make sure that such glaring weaknesses in the financial system should have been resolved many years ago.

The fact that they are still extant deserves some more substantive explanation, given the magnitude of the potential impact on the economic welfare of so many people.

It makes the constant criticism of Greek reticence to implement agreed market reforms appear trivial, by comparison.

Experience also teaches us that if these issues haven’t been resolved after this period of delay they are unlikely to be resolved in the future, that is, not until the next crisis. It may be that George Bush was wrong.

You can get fooled again.

Eugene McErlean is an expert on corporate governance and banking.


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