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3 Law & Fin. Mkt. Rev. 1 (2009)

handle is hein.journals/lawfinancmr3 and id is 1 raw text is: Guest Editorial

Rebuilding the credibility of markets and
The financial crisis has decimated the public's trust in regu-
lators, banks and financial markets. Surveys show that nearly
80% of people blame regulators for the crisis, but the disap-
probation is heaped on them and on the banks in almost
equal measure. Meanwhile, investors are pulling out of the
equity markets and reverting to cash, or even withdrawing
from the financial markets completely. Sales of reinforced
safes have apparently never been higher.
Lack of confidence in regulators, banks and markets
would not be so critical if financial markets were somehow
self-contained. Yet, as the crisis is clearly demonstrating, the
real economy needs the financial system to function, and
needs governments and regulators to ensure that it does so.
Although in the short term most of the political attention is
currently focused on designing fiscal policies and other
macro-economic tools in an attempt to limit the severity of
a recession, in the medium term attention will have to turn
to rebuilding confidence in regulators, in the markets and in
the governance of banks themselves.
Rebuilding confidence means rebuilding credibility.
Rebuilding the credibility of regulators means restoring trust
in their ability to monitor and contain the risk-taking of
financial institutions. Restoring that trust is critical, but it
will take more than the production of new codes on
liquidity or exhortations on financial institutions to improve
their risk management to achieve this. This is not to say that
new rules are not needed. The crisis has revealed that there
were failings in the rules - insufficient attention to liquidity,
the lack of oversight of the credit derivatives markets, failings
to regulate the mortgage advisory and sales processes, partic-
ularly in the United States - all are examples of where new
rules are needed. But new rules, while necessary, are not
sufficient, for the crisis has revealed three further critical and
systemic weaknesses, all of which need to be addressed if
confidence is to be restored.
The first weakness has been well recognised, and this is
that although financial markets are global, regulation is still
firmly national, despite the plethora of international codes
that exist. The realisation of the ambition of global regula-
tion may have receded further following the experience of
the Lehmans' insolvency, which saw US discrimination
against foreign creditors, and which may reduce the willing-
ness of national regulatory authorities to rely on foreign
liquidity in the future. The international framework of
financial regulation is highly fragmented, lacks any clear lines
of authority and so is fatally slow to respond either to
emerging signs of problems or to crises when they occur.
There is no mechanism for ensuring that national regulators
take macro-economic considerations into account in their
regulation of individual firms. There is no means of collating
information on the activities of global financial institutions

or the hidden markets of the shadow banking system.
There is no one body with undisputed authority to lead
policy-making in this area, or to insist that national regula-
tors perform their tasks to a certain standard.
Addressing these structural weaknesses is a matter of insti-
tutional design and political will. It is a difficult task, but not
as hard as addressing the second and third systemic weak-
nesses in financial regulation. These are that crisis has shown
that regulators lacked both an understanding of the real
dynamics of the markets and of the concentrations of risk
that were developing, and the confidence or ability to chal-
lenge banks, and others, about the levels of risk they were
Regulators were not alone in lacking a clear under-
standing of the overall nature of the distribution of risks. It is
becoming increasingly clear that financial institutions them-
selves were unaware of the nature and extent of risks to
which they were exposed. However, regulators, unlike indi-
vidual financial institutions, are in a position to develop an
aggregate view of the markets, even if they can never know
as much about the exposures of an individual financial insti-
tution as that institution does itself Further, those that did
have some awareness or did raise questions - and some
central banks had been issuing warnings for some time -
were insufficiently heeded.
Ensuring that regulators develop a fuller understanding of
the dynamics of the markets requires rebuilding their
capacity and, in some cases, redrawing their competences.
Rebuilding capacity needs both skills and resources. Finan-
cial regulators need to reskill and restaff, and that will be
costly, for they are competing for staff with financial institu-
tions who can offer significantly higher pay packages
(subject, of course, to the new regulatory ambition of
constraining remuneration).
The real challenge for financial regulators, however, lies in
addressing the third failing revealed by the crisis: that they
did not adequately contain the risk-taking of banks. A key
role of financial markets is to create and distribute risk. A
key role of financial regulators is to contain those risks such
that they do not impose systemic damage on the system as a
whole. But to what extent should regulators contain the
risk-taking of financial institutions? If regulation, either in its
design or in its implementation, is too risk averse, it will
inhibit innovation and competitiveness. Being too ready to
pick up the pieces can also lead to moral hazard, and thus
inadvertently exacerbate risk.
Ensuring that regulation is appropriately calibrated is
fiendishly hard. Getting political buy-in for the assessments
that regulators make is just as difficult. Regulators argue,
rightly, that any calls they may have made for financial insti-
tutions to restrict their risk-taking behaviour prior to the
crisis would have lacked any political support and been seen
as an unwarranted intrusion into the running of those insti-
tutions. In contrast, in the current political climate, no

Law and Financial Markets Review

January 2009

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