One of the most striking developments of the late 20th century was the explosion in the volume, speed and complexity of international financial transactions, and the resulting breakdown of effective regulatory control over the global financial system. The speed with which this process has gone into reverse since the onset of the financial crisis has been equally striking. Transactions in the global foreign exchange market, once confined to financing trade flows, peaked at around $4 trillion per day in mid-2008. At that pace, two days of foreign exchange trading would be sufficient to finance an entire year’s trade flows. The growth of private credit reached an annualised rate of $10 trillion at the same time.Economics as a Social Science

John Quiggin

English

Research Papers in Economics

 
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Economics as a Social Science: Financial Regulation 
After The Crisis 
By 
 
John Quiggin 
Australian Research Council Federation Fellow, University of Queensland 
 
 
 
 
 
Risk & Sustainable Management Group 
 
 
Schools of Economics and Political Science 
University of Queensland 
Brisbane, 4072 
rsmg@uq.edu.au 
http://www.uq.edu.au/economics/rsmg 
 
Risk and Uncertainty Working Paper: R10#4 1 
 
Economics as a Social Science: Financial Regulation After The Crisis 
 
One of the most striking developments of the late 20th century was the explosion in the 
volume, speed and complexity of international financial transactions, and the resulting 
breakdown of effective regulatory control over the global financial system. The speed with 
which this process has gone into reverse since the onset of the financial crisis has been 
equally striking. 
Transactions in the global foreign exchange market, once confined to financing trade flows, 
peaked at around $4 trillion per day in mid-2008. At that pace, two days of foreign exchange 
trading would be sufficient to finance an entire year’s trade flows.  The growth of private 
credit reached an annualised rate of $10 trillion at the same time.  
The market collapsed in the crisis of late 2008. According to the International Monetary Fund 
(2009), private sector credit growth fell by 90 per cent, and ‘Emerging bond markets virtually 
shut down for a period of time in the fourth quarter’.  
Although rescue measures by governments have restored credit flows, the system remains 
weak and unstable. The challenge facing governments and regulators will be to construct a 
new financial system and a regulatory architecture strong enough to prevent a recurrence of 
the bubble and meltdown that has largely destroyed the existing unregulated system. 
The essential features of a system of financial regulation to support market stability and 
prevent another meltdown are: 
   Linking and integrating national financial systems to produce a sustainable 
international financial architecture 
   Decoupling exchange rates from the vicissitudes of financial markets - the Tobin Tax 
   Guaranteeing and regulating the banks 
   Regulating innovation 2 
   An effective ratings system 
A new financial architecture 
The idea of a ‘global financial architecture’ is both misleading and unattainable. The 
keystone for any financial architecture is the institution that acts as lender of last resort for 
others.  This function is, and is likely to remain, one undertaken by national governments 
and their central banks. It follows that there can be no global financial architecture. Rather 
national systems of financial regulation must be linked and integrated to produce a 
sustainable international financial architecture. 
To achieve this, there must be no ‘offshore’ financial system, outside the agreements that 
govern the international financial architecture, but nevertheless allowed to transact with 
institutions inside the system. This issue has already arisen in relation to international tax 
avoidance and evasion, and will arise in an even more acute form in relation to the Tobin 
tax, discussed below.  
Fortunately, the OECD has already developed a strategy to address tax avoidance that will 
serve as a model for financial regulation. The Financial Stability Board, established as part 
of the response to the global financial crisis has already indicated that the tax haven model 
will be applied to ‘regulatory havens’ offering lax financial regulation. As with taxation, the 
process will undoubtedly be slow, but the mechanisms are in place to ensure that evasion of 
financial regulation through the use of offshore transactions can be prevented. 
The Tobin tax 
The long-advocated and long-resisted idea of a small tax on financial transactions, 
commonly called a Tobin tax, is the most promising option for  ensuring that exchange rate 
movements reflect the economic fundamentals of trade and long-term capital flows, rather 
than the vicissitudes of financial markets.   
A tax at a rate of 0.1 per cent would be insignificant in relation to the transaction costs 
associated with international trade or long-term investments. On the other hand, daily 
transactions of $3 trillion would yield revenue of $30 billion per day, or nearly $1 trillion per 
year. Since this amount exceeds the total profits of the financial sector (profits that are likely 
to be much smaller in future) an effective Tobin tax would imply a drastic reduction in the 
volume of short-term financial flows. It follows that the revenue from a Tobin tax, while 3 
significant, would not be sufficient to replace the main existing sources of taxation, such as 
income tax. 
The large literature on Tobin taxes has identified two significant problems with the simple 
proposal for a tax on international financial transactions.  
First, it is possible to replicate spot transactions on foreign exchange markets with 
combinations of forward, futures and swap transactions. To make a Tobin tax effective, it 
would have to be applied to all financial transactions, including domestic transactions. 
During the bubble era, when the few remaining taxes on domestic financial transactions 
were being scrapped to facilitate the growth of the financial sector, this was seen as a fatal 
objection. It has become apparent, however, that the destabilising effects of explosive 
growth in the volume of financial transactions are much the same, whether the transactions 
are domestic or international. 
The fact that a Tobin tax on international financial transactions would be integrated with 
taxes on domestic transactions suggests that, in all probability, revenue would be collected 
and retained by national governments. However, the suggestion that at least some of the 
revenue should be used to fund global projects, such as the international development goals 
of UNCTAD, remains worthy of consideration. 
The second problem is that the tax would require global co-operation, since otherwise 
financial market activity would migrate to jurisdictions that did not apply the tax. Although this 
will remain a problem in the post-crisis world, it is likely to be much less severe than 
indicated by earlier discussions, because of the much smaller number of separate 
jurisdictions that would need to agree, following the emergence of  the euro. It seems 
inevitable that most remaining European currencies, with the possible exception of the 
British pound, will disappear in the wake of the crisis, and that a Europe-wide regulatory 
system will emerge.   
To address the problem of ‘offshore’ financial centres, such as Caribbean island states, is a 
Tobin tax on transactions among complying jurisdictions may have to be supplemented by a 
punitive tax, at a rate of, say 10 per cent, on transactions with non-compliant jurisdictions. 
This would effectively ensure that non-compliant jurisdictions were excluded from global 
financial markets, though the penalty would be modest as regards trade and long-term 
investment flows. 4 
Regulating the Banks - Guarantees, regulation or narrow banking 
The core of financial regulation is the existence of a (partial or total) guarantee that bank 
depositors who exercise ordinary prudence will not lose their money. Until October 2008, the 
guarantee system in Australia was carefully ambiguous. Governments and the Reserve 
Bank implicitly assured both the general public and wholesale lenders that our major banks 
are completely safe, while simultaneously denying that their liabilities were guaranteed. As 
was both predictable and predicted, the contradictions in this stance were exposed the first 
time the system faced a serious crisis. The result was the unlimited guarantee we have now. 
We must now consider whether to maintain, modify or withdraw the guarantee. Whatever we 
do, the crucial issue that has not been faced so far is that publicly-guaranteed institutions 
require much closer regulation than is consistent with policies of financial deregulation. 
So, there are three policy options available.  
1.  The first is the maintenance of the existing guarantee, and a comprehensive 
re-regulation of the system. This would not mean a return to the system that prevailed 
before the 1970s (no such return is ever possible), but it would require direct control over 
the allowable range of products, the setting of interest rates, fees and charges and the 
allocation of lending between sectors of the economy. 
2.  Current government rhetoric suggests the desire to return to something like the old 
system, with deposit guarantees being withdrawn once the crisis is over. But clearly, we 
cannot go back to the old ambiguity. If the guarantee is withdrawn, this will be a clear 
statement to depositors that they must make their own judgements about the safety of 
their money. It was in this context that the idea of a publicly-owned and publicly 
guaranteed savings bank was suggested. 
3.  The third option, in some ways a compromise, is that of narrow banking, in which publicly 
guaranteed banks stick to a tightly regulated range of well understood activities. This 
allows for a completely separate set of financial institutions, of which stock markets are 
the exemplar, where government guarantees are ruled out in advance. These would 
offer higher returns but no possibility of transferring risk to the public. This is my 
preferred option. 5 
Narrow banking 
Post-crisis financial regulation should begin with a clearly defined set of institutions (such as 
banks and insurance companies) offering a set of well-tested financial instruments with 
explicit public guarantees for clients, and a public guarantee of solvency, with nationalisation 
as a last-resort option. Financial innovations must be treated with caution, and allowed only 
on the basis of a clear understanding of their effects on systemic risk. 
In this context, it is crucial to maintain sharp boundaries between publicly guaranteed 
institutions and unprotected financial institutions such as hedge funds, finance companies, 
stockbroking firms and mutual funds. Institutions in the latter category must not be allowed to 
present a threat of systemic failure that might precipitate a public sector rescue, whether 
direct (as in the recent crisis) or indirect (as in the 1998 bailout of Long Term Capital 
Management). A number of measures are required to ensure this: 
   Ownership links between protected and unprotected financial institutions must be 
absolutely prohibited, to avoid the risk that failure of an unregulated subsidiary will 
necessitate a rescue of the parent, or that an unregulated parent could seek to 
expose a bank subsidiary to excessive risk. Long before the current crisis, these 
dangers were illustrated by Australian experience with bank-owned finance 
companies, most notably the rescue, by the Reserve Bank, of the Bank of Adelaide 
in the 1970s. 
   Banks should not market unregulated financial products such as share investments 
and hedge funds. 
   The provision of bank credit to unregulated financial enterprises should be limited to 
levels that ensure that even large-scale failure in this sector cannot threaten the 
solvency of the regulated system. 6 
In the resulting system of ‘narrow banking’, the financial sector would become, in effect, an 
infrastructure service, like electricity or telecommunications. While the provision of financial 
services might be undertaken by either public or private enterprises, governments would 
accept a clear responsibility for the stability of the financial infrastructure. 
Financial innovation 
The prevailing rule has been to allow, and indeed encourage, financial innovations unless 
they can be shown to represent a threat to financial stability. With an unlimited public 
guarantee for the liabilities of large financial institutions, this rule is a guaranteed, and 
proven, recipe for disaster, offering huge rewards to any innovation that increases both risks 
(ultimately borne by the public) and returns (captured by the innovators). There must be a 
reversal of the burden of proof in relation to financial innovation. 
The process of financial innovation, involving either the creation of new financial instruments 
or the design of new financial strategies for firms (often termed ‘financial engineering’) was a 
central feature of the era of market liberalism. The growth of finance has been almost 
unstoppable. Seemingly major financial crises like the stock market crash of 1987 or the 
NASDAQ crash of 2000 stimulated the development of yet more innovative responses. Even 
the exposure of spectacular fraud at the Enron Corporation, which had been nominated by 
Fortune magazine as 'America's most innovative' for six years in succession, did little to dent 
faith in the desirability of innovation. 
It is now clear that unrestricted financial innovation played a major role in the advent of 
financial crisis, by facilitating the growth of unsound lending and by undermining systems of 
regulation. There is an inherent inconsistency between unrestricted financial innovation and 
a regulatory system aimed at preventing the failure of financial systems or at insuring market 
participants against such failures. Guarantees create ‘moral hazard’ by allowing financial 
institutions to capture the benefits of risky investments, while shifting some or all of the 
losses to government-backed insurance pools.  
Moral hazard can only be offset by the design of regulatory mechanisms that discourage 
excessive risk-taking. But, as the literature on  mechanism design has shown, the 
effectiveness of such mechanisms depends on the existence of stable relationships between 
the observable variables that are the subject of regulation and the risk allocation that 
generates them. Financial innovation changes the relationship. In the presence of moral 7 
hazard, therefore, there is an incentive to introduce innovations that increase the underlying 
level of risk while leaving regulatory measures of risk unchanged. 
It follows that the only sustainable approach to financial innovation is one in which proposed 
innovations are introduced only after the implementation of necessary changes to regulatory 
requirements and risk measures. If reliable risk measures cannot be computed, the 
associated innovations should not be permitted. 
A public ratings system: capital adequacy, transparency and risk assessment 
Another important regulatory adjustment will be the end of the system by which prudential 
regulation has been, in effect, outsourced to ratings agencies such as Standard & Poor’s 
and Moody’s. Agency ratings have been enshrined in regulation, for example through official 
investment guidelines that require regulated entities to invest in assets with a high rating 
(AAA in some cases, investment grade in others) or provide those responsible for making 
bad investment decisions with a ‘safe harbour’ against claims of negligence if the assets in 
question carried a high rating. For these purposes at least, an international, publicly-backed 
non-profit system of assessing and rating investments is required. 
Conclusion  
 
The temptation to put off until calmer times questions about our financial vulnerability has 
proved irresistible so far. Looking at the current global scene, however, it seems unlikely that 
economic calm will return any time soon. A careful examination of the vulnerabilities in our 
financial system is an urgent task for Australia and the world 
 
 

Economics as a Social Science: Financial Regulation After The Crisis

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