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Christopher P. Buttigieg*

1. Introduction

The financial crisis, which was unprecedented in its scope, brought to the brink of

collapse the world financial system and contributed to a sharp decline in economic

output and employment around the globe.1 Like every historical event, the crisis came about as a consequence of the combination of different factors. An economic policy of low interest rates in the United States (hereinafter ‘US’) during most of the twenty first century, had been driven by economic conditions that were created by the bursting of the stock market bubble in the 1990s, encouraged the leveraging of portfolios, thereby increasing the level of liquidity in the economy and in financial markets.2 This, coupled with a general perception that prices in the housing markets will always be on the increase, encouraged the taking of disproportionate loans for investment in the property market which generated a property price speculative bubble.3 In part, it was also caused by new trends in the financial sector such as the application of the ‘originate to distribute model4’ in bank lending, which involves the origination of loans for the * The author is a Deputy Director within the Securities and Markets Supervision Unit of the Malta Financial Services Authority and represents the Authority at various expert group meetings of the European Securities and Markets Authority (previously the Committee of European Securities Regulators). He has also participated in the negotiations on the Alternative Investment Fund Managers Directive as a technical expert within the European Council. Mr. Buttigieg joined the Authority in 2000 as a manager within the Investment Services Unit and has twelve years of professional experience as a securities regulator. During this period he has gained practical experience in different areas of financial supervision including the off-site and on-site monitoring of financial institutions and the investigation and enforcement of financial product mis-selling and of financial market abuse. He is a certified public accountant in Malta, has a Masters degree in Financial Services from the University of Malta and a first class Masters degree in European Law and Society from the University of Sussex (UK). A Chevening Scholar, Mr. Buttigieg is also an assistant lecturer within the Banking and Finance Department of the University of Malta and is currently reading for a D.Phil in EU Law at the University of Sussex (UK). His research deals with the EU’s regulatory response to the 2007-2009 financial crisis and aims at contributing to the ongoing debate on the governance of financial regulation within the EU. The views expressed in this paper are solely those of the author at the time of writing and do not engage any institution he is affiliated with including the Malta Financial Services Authority.

K R French and others, The Squam Lake Report – Fixing the financial system (Princeton University Press 2010) 1.

C A E Goodhart, The Regulatory Response to the Financial Crisis (Edward Elgar Publishing Limited 2009) 10.

R J Shiller, The Subprime Solution: How today’s global financial crisis happened and what to do about i’ (Princeton University Press 2008) – Chapters 3 and 4 provide a detailed explanation of property bubble in the USA.

For a detailed examination of the originate to distribute model, refer to R H Weber & A Darbellay, ‘The regulatory use of credit ratings in bank capital requirement regulation’ (2008) Journal of Banking Regulation.

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purpose of repackaging into a structured financial instrument through securitisation and consequently the redistribution of the credit risk exposure to the loans.5 A remuneration model in the financial sector which encouraged the taking of excessive risk to maximise short term profits and the knowledge that in the end this risk would have been transferred to a third party, were catalysts for mortgage providers to lower their credit underwriting standards and target higher risk market segments such as sub-prime mortgages to issue loans for securitisation and redistribution.6 Irresponsible remuneration incentives coupled with faulty risk management models and a general reliance on credit ratings to calculate credit risk7 encouraged: [i] the issuing of high credit ratings for these structured finance instruments based on sub-prime loans;8 [ii] the issuing by insurance companies of credit default insurance to cover the default of these financial instruments, and [iii] the wide investment in structured financial instruments by financial institutions around the globe without adequate internal risk management assessment of their real credit worth.9 In the end, the property price bubble burst and in 2007 the US experienced a substantial increase in delinquency and foreclosure for sub-prime loans that created uncertainty and turmoil in the market for structured finance instruments which were backed by these loans.10 This led to severe financial losses for US and European financial institutions which had exposure to these structured finance instruments. As a consequence of the interconnectedness and interdependence of financial institutions, severe systemic instability was generated by a general reduction of mutual trust between financial institutions and by the drying up of the inter-bank liquidity markets.11 What had started as a liquidity crisis turned into a financial market emergency and finally into a general systemic crisis.12 The world experienced a series of financial failures which culminated with the collapse of Lehman Brothers at the end of the third quarter of 2008, after which there was the worldwide fear of a possible breakdown of the entire financial system. The functioning of the financial system D Chorafas, Financial Boom and Gloom: The Credit and Banking Crisis of 2007 – 2009 and Beyond (Palgrave Macmillan 2009) 133.

G l Clementi and others, ‘Rethinking compensation in financial firms’, Ch 8 in V V Acharya and M Richardson, Restoring Financial Stability: How to repair a failed system (John Whiley and Sons 2009).

In this article the term ‘financial institution’ has been used in its most general sense to refer to all types of financial services providers that are subject to financial regulation and supervision including credit institutions, investment firms and collective investment schemes.

L J White, ‘The Credit Rating Agencies: Understanding Their Central Role in the Subprime Debacle of 2007-2008’ (2009) Critical Review http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1434483 accessed February 2010.

Clementi and others (n 6).

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V V Acharya and others, ‘A Bird’s-Eye View: The Financial Crisis of 2007-2009: Causes and Remedies, Chapter 8 in V V Acharya and M Richardson, Restoring Financial Stability: How to repair a failed system (John Whiley and Sons 2009).

Acharya and others (n 11).

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became possible only after extensive public rescues of systemically relevant financial institutions,13 which allowed the stabilisation of the financial system so that financial institutions could once more support economic growth.

The financial crisis also brought into sharp focus the shortcomings of the model for financial regulation14 and mechanisms for financial supervision,15 which at the time were in force at international, regional, and national level. These had failed to predict the risks and consequently, did not identify and successfully mitigate the crisis. The financial crisis triggered a comprehensive rethinking of the scope of financial regulation and a broad policy response in favour of a wider and more intrusive financial regulation and supervision. Various regulatory initiatives have been proposed, some of which have been adopted or are in the process of being adopted in order to address the ambiguities of financial regulation and the inefficiencies of financial supervision. While the reforms are mainly aimed at mitigating systemic risk, other financial market failures are being addressed, such as the lack of investor protection and governance issues arising from conflicts of interest and market integrity, such as market abuse.

In the European Union (hereinafter ‘EU’), the policy response to the financial crisis has been led by the seminal De Larosiere Report, which identified the weaknesses of financial regulation and supervision and made recommendations for the strengthening of the financial system. These recommendations have been endorsed and are being implemented by the European Institutions.16 In the US, the regulatory changes were adopted in the widely debated Dodd-Frank Wall Street Reform and Consumer Protection Act.17 The measures taken in Europe and the US have generated an extensive academic, political, and public debate on the objective and scope of financial regulation and the remit for financial supervisors. In the midst of this subject one finds the theories and objectives of financial regulation. To comprehend fully the forces that drive financial regulation, it is essential to understand the theoretical framework that accounts for the origins of and the rationale for regulation, and a proper knowledge of the objectives which the regulation of financial services aims to achieve.

In this article the term ‘systemically relevant financial institutions’ may be defined as those institutions that are large in scale and have complex interconnections with other financial institutions and that consequently the failure of which would pose a large threat to the stability or confidence in financial markets.

Financial regulation is construed as referring to the employment of legal instruments for the implementation of social-economic policy objectives in the field of financial services.

Supervision of financial services denotes the sustained and focused control exercised by an administrative regulatory agency over the activities of providers of financials services.

Jacque De Larosiere, ‘The High-Level Group on Financial Supervision in the EU – Report’ (25 February

2011) http://ec.europa.eu/internal_market/finances/committees/index_en.htm accessed August 2011.

Dodd-Frank Wall Street Reform and Consumer Protection Act: An act to promote the financial stability of the United States by improving accountability and transparency in the financial system, to end ‘too big to fail’ to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes.

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The aim of this paper is to make some preliminary comments on the continued validity of the theories and objectives of financial regulation in the light of the financial crisis and the post-crisis policy response, mainly by reference to the European scenario. The main contention of this paper is two-fold. Firstly, the post-crisis policy response may be explained as a combination of factors that surface from the theories of regulation.

Secondly, the causes of the financial crisis and the subsequent regulatory measures which have been proposed sustain the continued validity of the objectives of financial regulation. It is also argued that regulatory and supervisory action to realise a specific objective of financial regulation could, at times, generate tensions with and weaken the realisation of other regulatory and economic objectives. The paper also demonstrates the difficulties that could surface in finding the right balance between achieving the objectives of financial regulation, while avoiding instances of over-regulation by respecting the principles of proportionality, subsidiarity, and the fundamental rights of members of society.

The rest of this paper is divided into three other sections. The next section examines the public and private interest theories of regulation and concludes by highlighting their validity in understanding the rationale behind the policy response to the financial crisis.

The third section evaluates the objectives of financial regulation in the light of the causes which brought about the financial crisis and the regulatory tools devised by policy makers in order to create order within the financial system. This section concludes that the financial crisis has strengthened the case for regulation to safeguard systemic stability; to protect the investor; and to ensure that financial markets are fair, efficient and transparent. The final section makes some additional concluding remarks.

2. Theories of Regulation The development of market economies has been conditioned by the ideas of two main schools of thought, whose views are reflected in two systems of economic organisation,18 that is the market system and the collectivist system.

The market system, which is to a large extent based on the capitalist ideology, is characterised by market freedom, where individuals and in particular the industry, are subject to very simple controls and are otherwise uninhibited from pursuing their own welfare objectives.19 In a market system, the economy is supported by the legal order, particularly through instruments of private law20 which have a facilitative function by offering a set of official arrangements through which the relationship between individuals is regulated and as a consequence of which they can conduct their activities and carry out their business. Consequences of a private law nature relate to, for example, the nullity of a contract and right to compensation or restitution. Private law is distinct from public law. The latter regulates the relationship between the general An economic system is composed of all the institutional means through which national resources are used to satisfy human wants.

A Ogus, Regulation: Legal Form and Economic Theory (Hart Publishing, 2004) 1.

As Ogus explains, private law is predominantly facilitative in character. Its foundational concepts are property, enabling society’s resources to be exploited and enjoyed by individuals, and contract, which gives security to the process required for those resources to be directed to their most valuable uses.

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