NEW YORK - Most financial transactions are dependent upon trust, but the last two decades of deregulation have eroded that trust and created a global crisis of confidence, according to experts who met last week at a global forum in the heart of New York's financial district.
"Our existing financial system has failed spectacularly," said Lord Adair Turner of Ecchinswell, chairman of the UK Financial Services Authority, at a Chatham House forum held at Chase Manhattan Plaza. "We have been through 20 years of almost limitless deregulation. In hindsight, deregulation was the wrong thing to do."
At last month's Group of Twenty summit in London, world leaders agreed that sweeping new changes must be made to national and international regulations.
Innovative minds don't like to be constrained by rules, but the past few years have shown that if left unchecked, a few bad apples can spoil the barrel.
"Not all innovation is equally socially useful," Turner said. "Financial innovation was being used to derive economic rents, not to improve the economy."
Turner said the world needs to redesign the banking system so that it is focused on the core and essential functions it provides to the economy, namely that of lending. Nations should toughen up their regulatory bodies to keep a closer watch on where the money is moving.
Preventing abuse while making sure not to stifle innovation requires a delicate approach, and national systemic risk regulators could be created "to take away the punchbowl before the party gets out of hand," he said.
"The government's job is to keep greed in check," said William Isaac, chairman of the Secura Group and former chairman of the Federal Deposit Insurance Corp. Greed is a natural and necessary market force, he said, but "if we don't have proper regulations in place, greed will bring the system down."
This crisis offers governments a rare opportunity to improve and streamline the regulatory process, allowing the creation of more thoughtful and prescriptive regulations, said Annette Nazareth, a partner with Davis Polk & Wardwell's financial institutions group and a former commissioner at the Securities and Exchange Commission.
"We need better risk management and risk assessment," she said. "Risk management was nowhere near as robust as we thought."
When everything was going up, managers' faith in risk models was overly optimistic, she said, and "the widespread disregard for tail risk was quite troubling."
"You can reverse-engineer almost anything to get the result you want," Nazareth added. "We went from having a free-market system to having free-for-all markets."
The good times seemed like they would go on forever, until the summer of 2007, when the credit boom rapidly swung into reverse. This sea change was caused by "perverse incentives, excessive complexity and global imbalances," said Jean-Claude Trichet, president of the European Central Bank, in a lunchtime speech under the vaulted limestone ceiling of the Federal Reserve Bank of New York.
"The asset cycle turned, and many of the missing links in the financial chain were exposed," Trichet said. "Investors suddenly lost confidence. After years of high profits and exceptional risk tolerance, markets became extremely discriminating about financial risk."
Underfunded regulators were spread too thin in recent years and were unable to keep up with the rapid pace of innovation, said Duncan Niederauer, CEO of NYSE Euronext. "We are now facing a period of re-regulation, but hopefully not overregulation."
"In a short period of time, so much wealth has been destroyed for so many by so few," said Christine Lagarde, France's minister of economy, finance and employment. "We need to put in place better, more comprehensive regulations so what caused the crisis does not happen again."
Financial industry veterans know that new regulations won't eliminate financial crises in the future, but the right changes can limit the extent of future crises and reduce their frequency, said Sir Andrew Crockett, president of JPMorgan Chase International.
"Certain markets don't function adequately and stably without regulation," he said, but enforcement of national regulations gets complicated at the global level.
"Markets are global, and the players are global, but the regulations are national," he said.
Crockett said there are unintended consequences to having too many regulations, such as placing strict regulations on one area to stop certain activities, only to watch those same activities move to less-regulated areas or countries. He said he supports the idea of countries having their own national systemic risk regulators to oversee the broader economy.
"Crisis resolution and management will be international in nature, but we won't have a global authority," he said. "We will have to rely on national regulators."
The already heavily regulated banking sector will likely bear the brunt of these new changes, due to the large role it played in the current crisis with overleveraging. New rules will place much higher capital requirements on banks and could require them to keep approximately 25% of their value in capital, experts estimate.
There are profound differences between European and American financial structures, Trichet said. While the U.S. has a primarily market-based financial system, the European area is largely bank-centered, he said.
"Clearly, there are differences in central banks' approaches to managing the crisis," he said. "In my view, these reflect profound differences in the economic structures within which central banks operate. But they do not reflect conflicting views on fundamental principles. Central banks around the world are united in purpose."
Trichet said the overarching aim of global regulators is to restore confidence, take measures to anchor expectations and lay the groundwork for a return to sustainable prosperity. Governments must balance the need to take appropriate action with the obligation to return to a sustainable path in the near future.
What the world needs now is "an effective, efficient, convincing, and quick implementation of the decisions which have been recommended by the Financial Stability Board, the International Monetary Fund and the World Bank and approved by the G-20," Trichet said. "In crisis periods, time is of the essence. At this stage, we do not need new decisions, but resolute and rapid implementation."
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