FINANCIAL REGULATIONS AND THE BASEL ACCORDS.Written by MOSES ORUAZE DICKSON

ABSTRACT

Since the dawn of the twenty first century, the global banking architecture has endured a tsunami of destructive events that have altered the shape of financial regulation in varying ways leading to the creation and subsequent adoption of a new Basel Accord. Basel III emerged amid turmoil in the global financial environment emanating from Subprime Mortgage crisis in the United States. Financial institutions from across the globe from Northern Rock in UK to Lehman Brothers in the US were victims of this crisis. This thesis explored the regulatory response to the subprime mortgage crisis with particular emphasis on the Basel III accord. Basel I and II were subject to a circumspect examination and critiqued in order to identify the failures that contributed to the financial crisis and the extent to which Basel III has resolved them. This research relied on doctrinal approach by examining the core provisions of the Basel III accord such as capital adequacy in a bid to identify the impact the new developments will have on the financial sector and its goal of global financial stability. As a result, a way forward in terms of reforming the Basel Accord and promoting global financial stability provided. Thus, this thesis will inform legal and economic circles on the regulatory failures prior to the financial crisis and the reforms under Basel III as well as its limitations.

DEDICATION.

To a life of learning and hard work.

TABLE OF CONTENT page

Abstract 1Dedication

2

Chapter one 1.1 Introduction 4

1.2 The background to this research 5

1.3. Research questions 6 1.4. Methodology 7

Chapter two:

Theoretical and Literature Review 9

2.1 The Concept of financial regulation 9

2.2. The Subprime Mortgage Crisis through the lens on an economist 11-12

2.3 The impact on UK 132.4 Literature review 14-15

CHAPTER THREE

3.1 The Basel I Accord 1 16

3.2 The rationale behind the Accord 16

3.3 The Basel I limitations on minimum capital requirement 18-19

3.4 The drivers for reform 20-21

CHAPTER FOUR

4.1 The Basel II accord 22

4.2 Minimum capital requirement 23-27

4.3 Supervisory review 28-29

4.4 Market discipline 304.5 Global implementation of Basel II

304.6 The Basel II flaws and global financial

31 Crisis4.7 The reform of Basel II 32-33

CHAPTER FIVE

5.1 The proposed Basel III reforms 34

5.2 The challenges and limitations 35

5.3 Financial stability – capital rules Basel II and III 36

5.4 Basel III regulating against future financial instability 37

5.5. A critique of Basel III 375.6 Future proposals 385. 7 Recommendations

39-42 5.8 Conclusion 42-45 5.9 Bibliography 45- 57

1.1. Introduction

The turn of the twentieth century was accompanied by concerns over the future sustainability of the global financial market. The century was welcomed by a dot.com bubble which saw the growth of internet business halted by a sudden bust and corporate governance challenges highlighted in the collapse of Enron.1 However, both laid the foundation for an even more disastrous event that gripped the global financial economy between 2007-2009 leading to the demise of many household names such as Lehman

1 Peter C. Fusaro, Ross M. Miller, What Went Wrong at Enron: Everyone's Guide to the Largest

Bankruptcy in U.S. History (Wiley, 2002); Kindleberger, Charles P., Manias, Panics,and Crashes: A

History of Financial Crises (Wiley, 2005, 5th edition).

Brothers and Northern Rock.2 In essence, the financial crisis was of global proposition and at the time of writing this thesis, countries are still wadding off its effects. However, this thesis focuses mainly on the financial crisis of 2007-2009 as opposed to the collapse of Enron or the busting of the dot.com bubble largely due to the contemporary nature of the topic and the regulatory responses made in recent years to bring harmony into the global market.

Following the collapse of the global financial architecture in 2007, the Basel Committee, which is a global supervisory body, introduced new standards to govern the global financial market.3 It reformed Basel II with a much-needed Basel III accord that set out to correct the failures of its predecessors. However, despite the reforms, a number of academics remain skeptical on whether real changes can occur and whether Basel III can usher in desired results.4 One of the underlying concerns relate to the increased complexity of financial products and the impact of securitization on risk taking. For example, the 2007-2009 financial crisis was coined the subprime mortgage crisis to reflect mortgage based debt assets that contributed to the financial crisis. The word subprime simply means subordinate to primary making.5 It is a loan given to people with bad credit rating who are not eligible for a prime loan, which is usually characterized by higher interest rates, poor quality collateral and less favorable terms, with a view to compensate for higher credit risks.

Although scholars have pointed the finger on a number of factors such as poor corporate governance practices and financial regulation as contributories to the financial crisis, this thesis largely focuses on the regulatory failures especially in relation to the securitization of subprime debt products.6 Subprime mortgages have a long and rich history that can be traced back to the late 1990s.7 During that period, there was a broad credit bubble in the United States and largely in Europe with a sustained housing boom in the United States. Gradually, excess liquidity, combined with escalating housing cost and an ineffectively regulated housing market, gave rise to an increase in nontraditional mortgages. These

2 Patterson, Laura A., & Koller, Cynthia A. Koller (2011). "Diffusion of Fraud Through Subprime Lending: The Perfect Storm." In Mathieu Deflem (ed.)Economic Crisis and Crime (Sociology of Crime Law and Deviance, Volume 16), Emerald Group Publishing, pp. 25–45.3 M. Nicolas J. Firzli, "A Critique of the Basel Committee on Banking Supervision" Revue Analyse Financière, 10 November 2011 & Q2 2012.4 Patrick Slovik; Boris Cournède (2011). "Macroeconomic Impact of Basel III". OECD Economics Department Working Papers. OECD Publishing. 5 Fried, Joseph, Who Really Drove the Economy into the Ditch? (New York: Algora Publishing, 2012)6 Koller, Cynthia A. (2012). White Collar Crime in Housing: Mortgage Fraud in the United States. El Paso, TX: LFB Scholarly.7 Pezzuto, Ivo (2013). Predictable and Avoidable: Repairing Economic Dislocation and Preventing the Recurrence of Crisis, Publisher: Gower Pub Co; New edition.

mortgage products were in most cases complex and did not reflect the borrower’s capacity to make repayments.

Despite the increasing complexity of mortgage products, there was little in terms of regulatory reform done to address the issue. This was partly due to a number of factors; mainly the lack of coordinated global approach to financial regulation and the mortgages mainly originated in the US rather than being a global issues in which case the Basel Committee would have been required to intervene. However, the collapse of Enron in 2001 laid the foundation for a global disaster and it is not surprising therefore that despite the adoption of Basel II in the late 2006 in response to the Enron disaster, we ended up facing a global financial crisis in 2007. It should be noted from the outset that at the time of financial crisis, Basel II was not yet fully implemented and it is arguable whether even if it was implemented, it could have halted the subsequent financial crisis.8

1.2 The background to this research

The subprime mortgage crisis left in its wake a smocking wreckage of companies destined for insolvency and brought the global financial system to its knees.9 However, caution must be exercised here given that it was mainly the western economies such US, UK and Greece that suffered the most from the crisis.10 Third world countries such as Nigeria and Bangladesh were not overly affected except for a few organizations such banks and mortgage firms that were caught up in the US mortgage debacle. Thus, most of the changes proposed under Basel III were aimed at western banks.11 The financial crisis became global largely due to the buying and selling of collateralized debt products such as subprime loans.12 It meant a bank in US would sell a mortgage instrument to a bank in china in real value and the bank in china would ride out the risk of borrowing by hoping for a full repayment plus the interest. Despite being a lucrative source of finance for banks and the ability to allow immobile and risky mortgages to be transformed into valuable assets, non-repayment would mean major losses for the foreign 8 The Financial Crisis Inquiry Report, Official Government Edition, Washington 2011, S 20.

9 Barth, James R.; Trimbath, Susanne; Yago, Glenn. The Savings and Loan Crisis: Lessons from a Regulatory Failure. Milken Institute pp. 58–59.

10 Roger C. Altman. "Altman-Foreign Affairs-The Great Crash of 2008". Foreignaffairs.org.

Retrieved February 27, 2009.

11 Susanne Craig (8 January 2012). "Bank Regulators to Allow Leeway on Liquidity Rule". New York Times12 Yuliya Demyanyk and Otto Van Hemert (2007-10-10). "Understanding the Subprime Mortgage Crisis". SSRN

bank. The mass default during the financial crisis resulted in billions being wiped off bank’s registers leading to a sustained financial crisis which has global spread.

Thus, given the growing internationalization of debt and the dangers it raises to the global financial architecture, it meant that global regulatory changes had to be put in place even as the regulators had many problems to address following the subprime mortgage crisis. First and foremost, to ensure that banks carry out due diligence rather than offering loans to individuals without the capacity to repay. Prior to the crisis, borrowers got high risk mortgages such as option-ARMs, and qualified for mortgages with little or in most cases no documentation.13 This created a situation where individuals with bad credit qualified for subprime loans with the bank solely glued to the high interest rate on offer. This practice gave birth to a serious glut of liquidity around the world that suddenly dried up at the height of the mortgage crises. The effect is that people, governments and businesses had monies to invest and they all developed a sudden appetite for mortgage related investments as a more secure way to earn more.

Secondly, banks continued to nurse mortgages in their books.14 It meant that if a person borrowed from let us say bank A, the person would need to make all the repayments to bank A and as such they are inevitably going to lose money if there is a default. However, if bank A sells the loan to bank B another bank who in turn goes on to resell this loan to possibly many other investors, unknown to the first original mortgagee, it increase complexity and alleviates the risk on bank A by transferring it to other banks. This made collateralized debt products such as subprime mortgages a very complex arrangement so much so that many investors only relied on rating agencies without even understanding the nature of their investment.

Furthermore, most of the collateralized mortgage products were in the form of Mortgage-Backed securities (MBS).15 These are investments that are to a large extent similar stocks and mutual funds whose values are mostly secured, backed or guaranteed by the joint values of the mortgages. This means that whenever an investor buys a MBS, he or she is not buying the actual mortgage but a simple promise to be paid the return on the joint value. This makes MBS a derivative since its value is derived from its assets. The risk is that in many cases, the borrower may default thereby depriving the investor of his initial investment. These complex

13 Lemke, Lins and Picard, Mortgage-Backed Securities, Chapter 2 (Thomson West, 2013 ed.).14 Lo, Andrew W. "Reading About the Financial Crisis: A 21-Book Review" (PDF).Draft: January 9, 2012. Journal of Economic Literature.15 Goolsbee, Austan (2007-03-29). "Irresponsible Mortgages Have Opened Doors to Many of the Excluded". Economic Scene (The New York Times).

security products created the ‘asset bubble’ which burst in 2006 with the subprime mortgage crises.

The Basel Committee had to intervene and its subsequent product is what is known as the Basel III. This thesis will not only explore the consequences flowing from the financial crisis but also the regulatory intervention. The thesis is largely premised on exploring the changes brought about by the Basel Committee under Basel III and the extent to which they have resolved the challenges that contribute to the subprime mortgage crisis. Thus, the aim of this research is to explore the causes of the financial crisis and reforms to the global financial architecture.

1.3. Research questions This is an economic-legal research into the nature of financial regulation and the extent to which securitization played a part in the subprime mortgage crisis. On the aspect of financial regulation, the Basel Committee reforms are the focal point of this research premised on highlighting the failures of the Basel I and II regime and the subsequent changes brought about under the Basel III accord. Thus some of questions that would be addressed is as follows:

a) What were the failures under Basel I and II and the reforms brought about by the financial crisis

In addressing that question, a key point that would be raised is that Basel II was implemented six months before the financial crisis. Thus, whereas Basel II was implemented in February, by September we had a financial crisis. It means Basel I was in play during the financial crisis. Thus the provisions of Basel I will be subject to a circumspect review to determine their shortfall and the contribution it made to the financial crisis.

However, other non-regulatory factors will also be considered in this research. It should be noted that following the dot.com bubble and bust in 2001, the U.S Federal Reserve system, under Chairman Alan Greenspen went on aggressively to expand credit (money supply).16 This expansion was followed by repeated lowering of its target for federal funds from 2001 at 6.25 percent ending at 1.75 percent that same year and reaching a low in the middle of 2003 at 1 per cent. In all of this, the actual federal funds were negative which meant that nominal rates were lower compared to real inflation rates for two

16 Benjamin M. Friedman (March 20, 2008). ‘’ chairman Greenspan’s Legacy’’. New York Review Books 55 (4).

Aversa, Jeannine (March 5, 2005); ‘’ Allen Greenspan Enjoys Rock Star Renown’’. Houston Chronicle. Retrieved December 7, 2011; Evans-Pritchard, Ambrose (September 17, 2007).’’Greenspan Was More a Rock Star Than Fed Sage’’. The Daily Telegraph (London). Retrieved December 7, 2011; Stahl, Leslie (February 11, 2009) ‘’Greenspan Defends Low Interest Rates’’. CBS News. Retrieved December 7, 2011.

and half years. However, regulatory authorities also played a role in the eventual collapse of the global financial system. The repeal of the Glass-Steagall Act of 1933 by the Clinton Administration in the US was another huge factor contributory to the financial crises.17 The repeal lifted the limitation on the creation of collateralized debt products and their proliferation at the turn of the twentieth century was largely due to this legal reform.18 Given that Basel III sought to reform these shortfalls, another question this research intends to address is whether Basel III will succeed.

b) To what extent have Basel III accord corrected the failures that led to the 2007 global financial crises and future concerns.

Thus, this question will inform legal scholars, banks and economists on the extent to which Basel III has corrected the failures of yesteryear. It is imperative to note however that Basel III only came into effect in 2015 with an implementation deadline stretching to 2025. It raises the question whether by the time most of the countries wake up to take into account these reforms, would another financial crisis be on the horizon? It is difficult to neither predict the outcome of a financial crisis nor forecast the impact the reforms would have on the banking sector, however the Basel accord introduces a revised version of rules designed to shepherd companies through rough economic conditions. Thus this research will also consider the question of whether the reforms are contemporary and would address contemporary issues rather than a reaction to problems of the past.

c) How can we reform the financial architecture to meet the demands of a new age to keep up with contemporary evolving global market?

This question will help to shed light on the failures of Basel III. Many issues have been highlighted by financial economists and legal scholars. Thus this research intends to inform legal scholarship on the extent to which the Basel III accord has reformed the failures of its predecessors and brought security and stability to the global financial system.

1.4. Methodology

This is an economic -legal study which examines the operation and effects of Basel III and other reforms on the global financial system.19 Economic-legal research has its theoretical and methodological base primarily in social sciences with the premise on 17 Barth, James R.; Brumbaugh Jr., R. Dan; Wilcox, James A. (2000),"The Repeal of Glass–Steagall and the Advent of Broad Banking" (PDF),Journal of Economic Perspectives 14 (2): 191–204.18 Benston, George J. (1990), The Separation of Commercial and Investment Banking: The Glass–Steagall Act Revisited and Reconsidered, New York: Oxford University Press.

finding efficiency. It aims to understand law as a driver of economic efficiency. This distinguishes it from black letter legal analysis which is premised on interpretation and analysis of case law and statutory provisions. This is why the methodologies used in this research are mainly empirical and social-theoretical rather than purely doctrinal. This study draws on economic theory in understanding the nature of financial regulation and whether the new reforms would secure the global financial architecture for many years to come.

Both theoretical conceptualisation and doctrinal analysis approaches are used in this study. First and foremost, conceptualisation of theory helps to understand how different study areas are linked together in order to form theory.20 According to Leshem and Trafford, it “provides theoretical cohesion to the evidence and conclusions from theory-building research”21 This is where concepts are contextualised in order to gain a deeper understanding and meaning behind them. Moving from the particular to the general helps to get a wider understanding of the issue. This is critical for theory development because it enables the researcher to make predictions and structure relationships between different variables being studied.

Secondly, this study aims to answer questions of how and why. Thus a doctrinal approach is necessary in order to interpret the provisions of relevant statutory instruments and reach a circumspect conclusion on the future of the global financial system. This study will look at the Basel III accord with a view to analyse and where possible critique the accord and see to what extent the problems of Basel I and II (issues of minimum capital requirement, supervisory review and market discipline) are addressed by Basel III. This methodology is mainly used in legal research and it allows for analysis of case law and provisions in order to find relationships or inconsistencies which can feed calls for reform. In this case, Basel II and I will be scrutinised in order to determine whether calls for reform were justified and also whether Basel III has adequately responded to these calls.

Other methodologies were deemed unsuitable for this type of research.22 For example, a case study approach is premised on identifying more than one case, such as bank crises and comparing them in order to find relationships and build or support literature as

19 Howell, K. E. (2013) Introduction to the Philosophy of Methodology. London: Sage Publications.

20Anfara, V. & Mertz, N. (2006), “Theoretical framework in qualitative research”, Thousand Oaks, CA: Sage Publications, London, pp. 23- 35. 21Leshem, S &Traford, V. (2007), “Overlooking the conceptual framework”, Innovations in Education and Teaching International, Volume 44, Issue 1: 93-105, p. 100.

a result. A case study approach would have meant using banks such as Lehman Brothers and Northern Rock to determine whether similar factors were at play in their collapse. According to Yin, a case study design should be used when the study aims to answer ‘how’ and ‘why’ questions.23 Similarly, it could mean comparing different financial crises in order to identify similar issues or causes. However, this research is mainly legal thus it focuses on the rules rather than causes and the extent to which failures attributed to rules in Basel I and II have been addressed. It means however, delving into the economic and social-scientific field in order to determine the causes and consequences flowing from the inadequate rules found under the Basel accord.

CHAPTER TWO:

Theoretical and literature review:

2.1 The concept of financial regulation

This chapter will explain the concept of financial regulation with a particular focus on the global effort to create a secure and stable financial system. It will provide a circumspect examination of the causes and regulatory response to the subprime mortgage crisis of 2007 -2009. This thesis focuses mainly on the developments made under the Basel III accord and the failures of its predecessors. It will also highlight key contributions to this global discuss in the literature review.

Financial regulation is premised on supervision of the financial market and its institutions both at international and domestic levels.24 The idea of regulating the financial system has for centuries been identified as necessary in view of the rising world economy. Global financial activity has grown faster than the world Gross Domestic Product (GDP) culminating in meaningful liberalization of financial markets and global capital flows in an ever technologically advancing

22 Creswell, J. (2003). Research Design: Qualitative, Quantitative, and Mixed Methods Approaches. Thousand Oaks, California: Sage Publications.

23 Yin, R. K. (2003), “Case study research, design and methods” 3rd Edition, Thousand Oaks: Sage, p13. 24CHIU, H. (n.d.). “Securities Intermediaries in the Internet Age and the Traditional Principal-Agent Model of Regulation: Some Observations from the EU’s Markets in Financial Instruments Directive” presented at the International Business, Law and Technology Conference, Copenhagen, 5-7 Dec 2006.

world.25As the world grows more in complexity so also the international financial system which affects lives of people, companies and international trade and all other factors that depend on it.

In the twenty-first century however, the global financial system experienced a slew of changes driven forward by increasing competitiveness and growing harmonization.26 With many institutions springing up both in the money and capital markets, the financial world has for long become intricate with closer inter-connectedness inside and even between institutions, firms and markets.27 This has brought an array of benefits to countries mainly through increased Foreign Direct Investment (FDI) and as a result, wide choices are available to investors, savers, borrowers and lenders.28All these and many more reasons made it imperative for creation of global regulations and guidelines with much emphasis on the achievement of specific objectives by putting breaks to halt the rapid market expansion which will otherwise threaten stability objectives. This culminated in the Basel Accord, aimed at setting a global framework for the regulation of financial institutions.29 Basel I for instance was a response to the liquidation of Cologne- based Herstatt Bank in 1973.30 The accord was premised on regulating credit and other risk weighting of financial instruments. The question as to whether it was successfully implemented would form a key part of the discussion in this thesis. In essence, the Basel accord was a fundamental invention that has gripped banking regulation in every corner of the globe and remains a cornerstone of modern financial regulation, having gone through two stages of amendment.

Historically, all attempts to regulate the financial sector have often been reactionary to one disaster or another. For example, the 25 Reinhart, Carmen; Rogoff, Rogoff (2009), This Time is Different: Eight Centuries of Financial Folly, Princeton U. Pr.; Simpson, D., Meeks, G., Klumpes, P., & Andrews, P. (2000). Some cost-benefit issues in financial regulation. London: Financial Services Authority.26For example, the creation of the Basel II and III accords are global policy measures driven in that direction. Kern Alexander “European Banking Union: a legal and institutional analysis of the Single Supervisory Mechanism and the Single Resolution Mechanism” European Law Review 2015 E.L. Rev. 2015, 40(2), 154-187; Basel Committee on Banking Supervision (2011), "Macroprudential Policy Tools and Frameworks", Progress Report to G20 (2011), http://www.bis.org/publ/othp17.htm[Accessed February 24, 2015].27P. Bolton and X. Freixas, "Corporate Finance and the Monetary Transmission Mechanism" (2006) 19 Review of Financial Studies 3, 829; Bofinger, Peter (2001). Monetary Policy. Goals, Institutions, Strategies, and Instruments. New York: Oxford University Press.28W. Bagehot, Lombard Street: A Description of the Money Market (H. S. King, 1873), p.68 ; See Basel Committee, Basel III: A Global Regulatory Framework for Resilient Banks and Banking systems (2011), pp.16–17.29Davies, H (1998), “Why Regulate?”. 1998 Henry Thornton Lecture, City UniversityBusiness School. Financial Services Authority, London, mimeo, November, Basel Committee, Core Principles for Effective Banking Supervision (1997), principle 6.30 Jones, David (2000). “Emerging problems with the Basel Capital Accord: Regulatory capital arbitrage and related issues.” Journal of Banking and Finance 24, pp. 35-58; Wagster, John D. (1999). “The Basle Accord of 1988 and the International Credit Crunch of 1989-1992.” Journal of Financial Services Research 15:2, pp. 123-143.

1994 Mexican financial crisis31 and the Asian crisis of 1997 signaled an urgent need for reform.32 This raises concern over the continued stability of the global financial architecture and whether law reformers can adequately respond to financial issues in a reactive rather than pro-active manner. Similarly in UK, after the collapse of the Bank of Credit and Commerce International (BCCI), the Bank of England introduced a string of reactionary financial rules33 including handing over its statutory supervisory functions on financial institutions to the Financial Services Authority (FSA). 34 The FSA was set up to in 1998 with the sole purpose of regulating the financial sector in a much more efficient and meaningful way.

There is therefore a clear responsibility placed on financial regulators to ensure that financial intermediaries and markets are not over regulated even though regulations should be proactive. Thus the supervision should be risk based instead of compliance based. In Sri Lanka for example, there are three main financial regulators, these are the Central Bank of Sri Lanka, the Securities and Exchange Commission (SEC) and the insurance Board of Sri Lanka (IBSL).35 As a result, 70 percent of the financial sector is supervised and regulated by the Central Bank thereby leaving 11 percent of financial institutions made up of insurance companies to IBSL. And SEC accounts for only 4 percent of the system, mainly a smaller capital market institutions.36 The remaining financial intermediaries are regulated by various authorities and a large number of them are even left unregulated. Ironically, Sri Lanka’s banking sector is currently operating on Basel I and in preparation for implementing the latest version of the Basel accord. In all, the essence of financial regulation is aimed at encouraging financial intermediaries to ascertain and manage risks without necessarily creating instability in any institution. It also aims to avoid ripple effects on the whole financial system that is dependent on public confidence with local, national and global ramifications. 31Victoria Miller (2000). "Central bank reactions to banking crisis in fixed exchange rate regimes". Journal of Development Economics 63 (2): 451–472. 32Delhaise Philippe F. (1998) Asia in Crisis : The Implosion of the Banking and Finance Systems. John Wiley & Sons; Kaufman, GG., Krueger, TH., Hunter, WC. (1999) The Asian Financial Crisis: Origins, Implications and Solutions. Springer.

33Peter Truell, Larry Gurwin, False Profits. The Inside Story of BCCI, the world’s most corrupt financial Empire, 1992, Houghton, Mifflin Company, Boston, New York,34 The FSA is now known as the Financial Conduct Authority (FCA); Kanas, Angelos, PURE CONTAGION EFFECTS IN INTERNATIONAL BANKING: THE CASE OF BCCI'S FAILURE, Journal of Applied Economics, Sunday, 1 May 2005;  Vina, Gonzalo. "U.K. Scraps FSA in Biggest Bank Regulation Overhaul Since! 1997". Businessweek (Bloomberg); Davies, H (1999), “Building the Financial Services Authority: What’s New?”. 1999 Travers Lecture, London Guildhall University Business School.Financial Services Authority, London, mimeo, March.35 Being lecture delivered by Ranee Jayamaha, Glimpse of Current Financial Regulation, Deputy Governor, Central Bank of Sri Lanka, Nov 2006.

36 Being lecture delivered by Ranee Jayamaha, Glimpse of Current Financial Regulation, Deputy Governor, Central Bank of Sri Lanka, Nov 2006.

2.2. The Subprime Mortgage Crisis through the lens on an economist

This part will touch briefly on the global financial crisis otherwise known as the subprime mortgage crisis.37 Since 2007, the United State of America (USA) and so many western global economies have struggled with the worst financial crisis since the great Depression.38 As a result, many major corporations entered into insolvency with large American (Lehman Brothers) European banks (Northern Rock) losing hundreds of billions in the process, leading to their untimely demise.39 Even the Standard and Poor’s (S & P) which is a major stocking index was not spared. It fell from 46 percent in 2007 to more than £1trillion in wealth between the height of the stock market in November 2008.40

37 PAGANO M. (2008), “The subprime lending crisis: lessons for policy and regulation”, UniNews, Unicredit, July; Cannata, Francesco and Quagliariello, Mario, The Role of Basel II in the Subprime Financial Crisis: Guilty or Not Guilty? (January 14, 2009). CAREFIN Research Paper No. 3/09.

38Keynes, John Maynard. "The World's Economic Outlook", Atlantic (May 1932); Garraty, John A. The Great Depression: An Inquiry into the causes, course, and Consequences of the Worldwide Depression of the Nineteen-Thirties, as Seen by Contemporaries and in Light of History (1986); Michael Simkovic, "Secret Liens and the Financial Crisis of 2008"American Bankruptcy Law Journal, Vol. 83, p. 253, 2009; Bezemer, Dirk J (June 2009). ""No One Saw This Coming": Understanding Financial Crisis Through Accounting Models" Munich Personal RePEc Archive. 

39 Joseph Fried, Who Really Drove the Economy into the Ditch? (New York, NY: Algora Publishing, 2012), 16–42, 67–119.; Fackler, Martin (October 23, 2008). "Trouble Without Borders". The New York Times. ; Sorkin, A. Ross. (Oct 2009) Too Big to Fail: The Inside Story of How Wall Street and Washington Fought to Save the Financial System—and Themselves. Viking Adult; Iris H.-Y. Chiu, Corporate governance: the missing paradigm in the mandatory bail-in regime for creditors of banks and financial institutions, Journal of Business Law, 2014.

40 kiran manda, Stock Market Volatility During The 2008 Financial Crisis, The Leonard N. Stern School of Business Glucksman, Institute for Research in Securities Markets Faculty Advisor: Menachem BrennerApril 1, 2010; The Leonard N. Stern School of Business Glucksman Institute for Research in Securities Markets Faculty Advisor: Menachem Brenner April 1, 2010.

As aforementioned, the financial crisis started from the US ‘subprime crisis during the summer of 2007 and rapidly spread to so many other advanced economies. It mainly affected companies with direct contact to subprime assets41 due to a gradual loss of confidence in so many asset classes.42 In the course of this, there was extreme exposure to local financial imbalances in a lot of advanced economies because of over reliance on large scale funding sources in the form of residential property assets.43 The causes of the financial crisis will be explored in subsequent chapters and they include failure of the credit agencies, Federal Reserve expanding credit, the repeal of the Glass –Steagall Act and subprime lending. The latter will be the main focus of this thesis.

The impact of the financial crisis had a major impact on so many economies around the world. For example, 5.5 million jobs in the USA were lost due to slow economic growth as a result of the financial crisis.44 Stock value was also not spared as the United States lost over $7.4 trillion in stock value between July 2008 to March 2009 accounting for $66,200 on average per household.45 According to the United States Federal Reserve, home values in the United States which were a contributory factor to the crisis lost $ 3.4 trillion in real estate wealth between July 2008 to March 2009 accounting for $30,300 per household. In addition, 500,000 additional foreclosures were made during the peak phase of the financial crisis based on this 2008 CBO forecast.46

Furthermore, financial institutions were also not spared as several banks were bailed out by the Federal government with taxpayers’ money while other banks which were unfortunate such as Lehman Brothers which went insolvent. This crisis spread wildly sending a global economic shock affecting numerous European banks

41 G. Amronin and A. Paulson, “Comparing Patterns of De- fault among Prime and Subprime Mortgages,” Economic Perspectives, Federal Reserve Bank of Chicago, Vol. 2, 2009, pp. 18-37; M. Flannery, “Capital Regulation and Insured Banks’ Choice of Individual Loan Default Risks,” Journal of Monetary Economics, Vol. 24, No. 2, 1989, pp. 235-258.

42Andrew Sheng, "Financial Crisis and Global Governance: A Network Analysis"  July 2009. 43 P. Dimou, C. Lawrence and A. Milne, “Skewness of Re- turns, Capital Adequacy, and Mortgage Lending,” Jour- nal of Financial Services Research, Vol. 28, No. 1-3, 2005, pp. 135-161; A. Cowan and C. Cowan, “Default Correlation: An Em- pirical Investigation of a Subprime Lender,” Journal of Banking and Finance, Vol. 28, 2004, pp. 753-771.

44Stijn Claessens and Neeltje van Horen, ‘The Impact of the Global Financial Crisis on Banking Globalization’ IMF Working Paper, October 2014.

45Andrew Sheng, "Financial Crisis and Global Governance: A Network Analysis"  July 2009.

46Collateralized Bond Obligation (CBO); Polo, L. (2013) The financial crisis of 2007/8: Misaligned Incentives, bank mismanagement and troubling policy implications. Economics, management, and financial markets, 8(2),11-56.

and causing failures, reduction in various stock indexes, market values of equities, derivatives and commodities47. As a political response, world political leaders, national ministers of finance and heads of Central Banks, took on a coordinated response to reduce and manage fears48. Yet the crisis continued unabated. By the end of October 2008, a global currency crisis started, pushing investors to transfer huge capital resources into much stronger currencies such as the dollar, Yen and the Swiss franc,49 thereby forcing smaller emerging economies to seek financial aide from the International financial monitory fund (IMF).

2.3 The impact on United Kingdom

The financial crisis created so many negative ripples in the entire global financial landscape including the UK, Canada and Russia.50 In the UK, financial regulatory enforcement and monitoring heightened during the financial crisis. The results indicated that the overall leverage ratios rose from pre-crisis (2006 and 2007) to crisis (2008 and 2009) years but later in the post-crisis era (2010 and 2011) it decreased.51 Thus, both equity and debt levels change during the financial crisis and post-crisis period. The findings showed that firms that had lower than industry average capital structure ratios in the pre-crisis period experience a gradual increase in their leverage during and post-crisis periods.

However, the firms that had higher than industry average capital structure ratios in the pre-crisis periods experienced a 47 Ravichandran, Dr. Krishnamurthy, Effect of Financial Crisis over Mergers and Acquisitions in GCC Countries (March 15, 2009; Lin, Justin Y. and Treichel, Volker, The Unexpected Global Financial Crisis: Researching its Root Cause (January 1, 2012). World Bank Policy Research Working Paper No. 5937.48 The G10 countries met around 2010 in UK to discuss the financial crisis and how it can be resolved; G20 urged to reject protectionism, BBC News,  Friday, 14 November 2008; Financial Stability Board. Overview of Progress in the Implementation of the G20 Recommendations for Strengthening Financial Stability. 10 April 2011.

49 Buckley, Ross P. and Arner, Douglas W., From Crisis to Crisis: The Global Financial System and Regulatory Failure (September 1, 2011). Kluwer Law International, 2011; University of Hong Kong Faculty of Law Research Paper No. 2012/002; Mohan, Rakesh. 2009. ―Global financial crisis—causes, impact, policy responses and lessons, ‖BIS Review 54/2009.

50 Dong, abdul, Andrew,The Differing Efficiency Experiences Of Banks LeadingUp To The Global Financial Crisis: A comparative empirical analysis from Australia, Canada and the UK,Springer Science+Business Media New York, 2013 pg 343.

51IOANNIS KOKKORIS ,Competition vs. financial stability in the aftermath of the crisis in the UK ,THE ANTITRUST BULLETIN: Vol. 59, No. 1/Spring 201.

significant decrease in the leverage ratios particularly in the post-crisis period mainly due to changes in their equity levels52.In Russia for example, foreign currency reserves were partially expended to adapt a slow but quite noticeable reduction of the exchange rate. At some point, the Central Bank increased interest rates in order to bring stability to the exchange rate thereby stiffening monetary conditions. By contrast, the external anchors of exchange rates in Mediterranean neighbours had to be more resilient. So many southern Mediterranean countries pegged their currencies to the US dollar whereas others, notably Morocco and Tunisia, closely shadowed the Euro.53

2.4 Literature review

The global financial crisis extended its shadow on uncertainty at the dawn of the twentieth century. Numerous scholars have documented the collapse of Enron in 2002 and the negative impact it had on bank liquidity. In essence, the collapse of Enron was a catalyst in the subsequent subprime mortgage crisis. In her paper, Emily Lee explored the developments leading up to the financial crisis and the failures under Basel I, II and the recently formulated Basel III.54 The scholar used a doctrinal approach when exploring the provisions of the Basel Accords and reached a judicious decision that Basel I contributed to the financial crisis. According to the scholar, Basel III was not well implemented by most of the developed and developing nations at the time of the subprime mortgage crisis. The failures in Basel I were thus evidence in the post Enron era in which capital adequacy requirements were set below the current minimum risk rate endorsed by Basel III.

The author contributes to research literature by arguing that Basel III provides a framework capable of shepherding financial institutions through a sustained period of financial harmony. However, such anticipated levels of financial benevolence are highly unlikely given that financial crises are a common occurrence especially in the developed nations. The reactionary rather than proactive approach endorsed by the Basel Committee also creates a danger that past mistakes might have been glossed over by ardent rules without sufficient research or diagnosis into the causes.

Although the scholar’s arguments are subject to criticism, the doctrinal approach employed in this research paper allowed for a consistent and pertinent approach that is likely to improve not only the veracity but also reliability of the findings. Thus, this paper is likely to 52Iqbal, Abdullah, kume, Ortenca, ‘Impact of financial crisis on firms’ capital structure in UK, France and Germany’, Multinational Finance Journal 2014, Vol. 18 Issue 3/4, p249-280. 32p.

53Wheelock DC, Wilson PW (2000) Why do banks disappear? The determinants of US bank failures and acquisitions. Rev Econ Stat 82:127–138

54 Emily Lee  “The Soft Law Nature of Basel III and International Financial Regulations” (2014) Journal of International Banking Law and Regulation, Vol. 29 (10), pp. 603-612 

receive the desired academic attention given the methodology employed and the comparative assessment of all three Basel Accords.

De Caria 55 describes the three goals of financial regulation to include; remedy and prevention of market failures; management of systemic risks; and protecting consumer and investors. All these principles when written down into rules, regulation and recommendations form basis of financial regulation. However, the supervision of financial institutions to ensure compliance with rules is often saddled on government regulatory agencies. Furthermore, in order to gain enough evidence over compliance with financial regulations, the cooperation of private companies such as audit companies, law firms, according to De Caria is needed.

Reinhart and Rogoff explored the 2007-2009 financial crisis and found a uncanny resemblance to the Asian financial of 2003. He argued that in an age of increased deregulation, it is important to ensure that banking institutions, which stand at the heart social and economic integration, are increasingly subject to regulation. In his view, the sub-prime mortgage crisis was caused partly by a lack of cooperation between market players and market regulators which led to the development of sophisticated high risk sub-prime products that culminated in the collapse of the global financial system.56

An earlier piece by Simpson, Meeks, Klumpes and Andrews explored the cost-benefit issues of financial regulation.57 This was prior to the financial crisis, at a period when Basel II was in its ascendance. The scholars reviewed financial regulatory practices across the EU and found a strong relationship between good corporate governance practice and financial regulation with a robust financial system. In essence, the study found that a good financial system must balance self-regulation and hard law rules unless they would end up with a system that encourages risky behaviour and poor corporate governance.

Ndendi and Ketuma examined the impact of Basel III principles, mainly capital requirements, liquidity requirements and leverage ratio 55 De Caria, R. 2011. “What Is Financial Regulation Trying to Achieve?”, Hayek society journal. Vol 9. Available online at http:/papers.ssrn.com/sol3/papers.cfm?abstract id=1994472 (Accessed May 9, 2015)

56 Reinhart, Carmen; Rogoff, Rogoff (2009), This Time is Different: Eight Centuries of Financial Folly, Princeton U. Pr. 

57 Simpson, D., Meeks, G., Klumpes, P., & Andrews, P. (2000). Some cost-benefit issues in financial regulation. London: Financial Services Authority.

as indicators of commercial bank performance.58 They measured this through the preferred return rate and risk appetite of shareholders. The study design was mainly a combination of qualitative and quantitative data. They found that an increase in capital does not necessarily result in increased financing costs, and higher leverage usually results in higher tax advantage and therefore lower capital. Thus the new Basel III capital ratios will prevent over-leveraging and reduce tax advantages while having significant impact on net income and portfolio allocation.

Damyanyy and Hemert analysed the quality of subprime mortgage loans and found that the quality of the loans deteriorated for six years consecutively before the financial crisis and that security givers were to a large extent aware of this.59 This provides important evidence that the rise and fall of the mortgage market followed a lending boom- burst scenario. This also shows that unsustainable growth leads to the collapse of the market. It also indicates that problems could have been detected before the crisis but were masked by the security traders.

Riddiough examined the causes of the subprime mortgage crisis with particular reference to shadow banking, hidden leverage in the consumer market, mortgage securitization and other creative financing schemes that contributed the financial meltdown.60 The author argues that activities of prominent financial institutions such as Lehman Brothers61 played a pivotal role in the financial collapse by creating long lasting spillovers of toxic products into the real economy. The paper follows an entirely historical approach by tracing the subprime mortgage crisis from its genesis and eventual burst in the US mortgage market. The scholar compared the 2007-2009 crisis to the 1857 US banking crisis as well as the 2003 Asian financial meltdown. The author reached a circumspect conclusion that there is an uncanny resemblance between all the crises.

This thesis offers immense support to contemporary literature which points to changes in share ownership and risk taking as potential contributories to the global financial crisis. This places immense pressure on law reformers to ensure that suggested changes to the global banking architecture meet the demands of a changing commercial and banking sector. These are factors that Basel III has sought to overcome. Thus this paper is highly relevant to this line of 58 Alain Ndedi & Henry Jong Ketuma “Exploration of the Impact of Basel III on the Performance of Commercial Banks” Saint Monica University, 2015.59 Yuliya S. Demyanyy & Otto Van Hemert “Understanding the Subprime Mortgage Crisis” Federal Reserve Bank of Cleveland, IMC Asset Management December 5, 2008.60 Timothy Riddiough “The First Sub-Prime Mortgage Crisis and its Aftermath” (2012) BIS Paper No. 64c 

61 Umar Burkhanov, ‘The Big Failure: Lehman Brothers’ Effects On Global Markets’’ European Journal of Business and Economics, Vol 2 (2011).

research as it supports the foregoing view that financial regulation must coincide with developments in the commercial sector in order to yield intended results. This also shows that in order for Basel III to succeed, minimum capital requirements and capital adequacy measures must not follow a one-size fit all approach but rather to be pragmatic in approach and nature. However, despite its contribution to research literature, especially on the changes in financial regulation proposed under Basel III, this thesis is unlikely to receive the intended attention it so ardently deserves. This is partly due to the methodology used, one premised on literature review rather than a comparative and quantitative approach that encompasses data collection and analysis. Thus, an empirical study that seeks to correlate the 2007-2009 crisis62 with its predecessors is necessary.

The next chapter will examine the Basel I accord. TO BE CONTINUED.

62 Bruce, Emmanuel Maxwell, Literature Review on Basel II Banking Regulation (November 7, 2010).