Introduce precautionary principle for financial products, or they will fail us

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Europe is in the process of re-formulating financial regulations and creating a new banking union, but new rules will give rise to new financial products, writes Suleika Reiners, and these may wriggle around the new rules. Financial innovations need to be tested and put to the precautionary principle no less than other aspects of society, she argues, and suggests that a new body could be set up to carry this out.

Suleika Reiners is a finance policy officer with the Hamburg-based think tank World Future Council

“One key driver of financial innovation is the desire to overcome regulation. Thus, regulations are followed by innovations whose main purpose is to circumvent the regulation. By multi-layered securitisation, banks spread the risks from their balance sheets, in order to avoid the equity capital requirements demanded by the Basel Accord. Meanwhile, the increased capital requirements under Basel III might easily cause banks to outsource risks to clients through new opaque financial instruments. A second key driver is tax avoidance. With some derivatives, for example, companies shift profits to earlier or later time periods. Hence without preventive testing of financial innovations ('finance TÜV' – TÜV is German name for road safety tests), regulation and supervision will always lag behind. The project of the European banking union will be completely overstrained. The same is true with regard to internal risk management.

It is not only banks but financial instruments as well which can be systemically important. The de Larosière-Report, which was conducted in the name of the EU Commission, already pointed that out in early 2009. The spread of complex financial innovations contributes to the growing shadow banking sector and its interconnections with banks as well as with insurance companies and investment funds. Additionally, the increase in complex financial instruments has led to a decline in credit business and securities emissions, which means a complete misallocation of resources.

Currently, the law-making process to separate or ring-fence banking activities has started in the US, France, the UK and Germany. Yet separating the wheat from the chaff does not get rid of the chaff. Furthermore, not all investment banking is chaff; it is a meaningful part of real economy finance as well. At the same time, there is chaff in retail banking, about which many retail clients can tell us. This means that we have to sort out the chaff, in order to come to a workable and effective financial system.

Therefore, a precautionary principle for financial innovations affecting the whole economy should be as self-evident as it is for electrical products and drugs. Financial institutions will have to prove that the financial instrument is beneficial to the real economy and is the most welfare enhancing option. It must be proven that the risk-reward-profile is positive.

We do not need millions of different financial instruments. The same purpose can often be fulfilled by a variety of financial instruments, which can be more or less useful or harmful to the real economy and to society. The alternatives of collateralised debt obligations (CDO) vis-à-vis simple covered bonds backed by real assets is a good example. Securitisation can be useful up to a point; savings banks, for example, use it to diversify their regional risks. However, re-securitisation is not needed by the real economy. It should be prohibited.

A concept of financial innovation testing needs to be developed and implemented. An immediate initiative by policy makers such as the G20 would be extremely well-received. Fewer financial instruments and more highly qualified and paid regulators and supervisors are necessary. Many decisions allowing instruments will be controversial. It will therefore be important to connect bodies like the Financial Stability Board with representation from the real economy, trade unions and consumer organisations.

The Bank for International Settlements already proposed a finance-TÜV – as a 'poisons list' – when the Group of 20 negotiated about key measures for financial market regulation 2009 in Pittsburgh. In Germany financial bets were earlier classified as gambling and legally unenforceable, in order to protect retail clients. This was abolished due to pressures from financial institutions ten years ago.

The effects of financial innovations lie both in their application and in their design. As a key preventive and efficient measure at the base of financial regulation, financial testing would facilitate and simplify new regulations. The risk of institutions “too complex to be supervised”, “too complex to be managed” or “too connected to fail” would be reduced. Effective market supervision could be made possible.”

Think tanks

The Worlds Future Council: website

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