Assessing Global Regulatory Impacts of the U.S. Subprime Mortgage Meltdown: International Banking Supervision and the Regulation of Credit Rating Agencies

• Author: Aldo Caliari
• Pages: 03

This Article was prepared for the symposium on Financial Markets and Systemic Risk: The Global Repercussions of the U.S. Subprime Mortgage Meltdown, co-organized by the Journal of Transnational Law and Contemporary Problems ("TLCP") at the University of Iowa College of Law, in conjunction with the University of Iowa Center for International Finance & Development ("UICIFD"). Aldo Caliari is the Director of the Rethinking Bretton Woods Project at the Washington D.C.-based Center of Concern. He holds a Masters of International Policy and Practice Program with a focus on economics and finance from George Washington University (2007). Prior to joining the Center, Aldo received a Masters Degree at American University in International Legal Studies, where he was honored with the Outstanding Graduate Award. He received his first law degree at the Universidad Nacional de Tucuman Law School, Argentina, in 1997. Mr. Caliari has been a member of the Center of Concern since 2000, where his project focuses on issues of global economic governance, debt, international financial architecture, and, particularly, linkages between trade and finance policy. He has been a consultant on these issues to several intergovernmental organizations-UNCTAD, UNDP, UN DESA, and the Office of the High Commissioner for Human Rights. He is routinely requested by governments, civil society networks, and foundations to speak, write, and act as an advisor.

Page 147

I Introduction

In 2007, a crisis in the subprime mortgage market in the U.S. began a financial crisis of global proportions. This Article looks at two areas where the U.S. subprime mortgage market crisis and its consequences triggered a debate that is paving the way for possible reforms. First, the U.S. subprime mortgage crisis caused a movement towards greater global regulation of international banking. Second, the U.S. subprime mortgage crisis forced investors and governments to reevaluate the role of credit rating agencies ("CRAs").

This Article will explain the possible causes for the U.S. subprime mortgage crisis and suggest possible reforms to international finance. Part II reviews a wide range of explanations for the crisis. Part II further analyzes the wide consensus among experts that the U.S. subprime mortgage crisis interacted with a number of features of the global financial system, especially in the last few years, to produce the global financial crisis.

Parts III and IV survey the range of current actions and proposals to address the alleged failures, focusing on questions of further regulation and strengthened global institutional infrastructure. These sections review actions and proposals by international bodies such as the Financial Stability Forum ("FSF"), the International Monetary Fund ("IMF"), the Basel Committee on the Global Financial System, and the financial services industry. These sections also analyze the arguments concerning the proper amount of regulation necessary to promote prosperity while avoiding another economic crisis.

Part V compares the financial crisis today with the financial crisis in East Asia in the late 1990s. Law and policy makers proposed many of the same actions and regulations to fix the East Asia financial crisis that are being suggested today. Part VI compares the features of the current financial regulation debate against the actions taken in the late 1990s with regards to the East Asian crisis. Using the responses to the East Asian crisis as a guide, this Article will try to predict the possible outcomes of the current proposals. Part VII closes with some concluding remarks on the financial crisis.

II Explanations of Causes of the Global Financial Crisis

In the summer of 2007, the world entered a financial crisis, which still shows no sign of abating at the time of this writing. Soaring delinquencies in Page 148 U.S. subprime mortgages triggered this economic crisis.¹ A number of official publications show a remarkable degree of consensus as to the main causes and elements that constitute the crisis. Many sources make repeated reference to the following causes:

1. The crisis followed a boom period with exceptional growth of credit worldwide.² "Benign economic and financial conditions" fed the boom for a long period of time.³ In this easy credit environment of capital abundance, the amount of risk and leverage that borrowers, investors, and intermediaries were willing to take on increased.⁴

2. Additionally, a wave of financial innovations fed the boom by expanding the system's capacity to generate assets and leverage.⁵ Structured finance instruments Page 149 became a commonly-traded derivative during this period.⁶

3. Banks and other financial institutions helped in the collapse by establishing off-balance-sheet funding and investment vehicles. ⁷ These investment vehicles, in turn, invested in complex, structured products comprised of mortgage-backed securities. ⁸ This process was encouraged by the risk management practices in financial firms, their regulation, and their supervision.⁹ Page 150

4. The increased competition among lenders encouraged a relaxation of lending standards, most notably in the U.S. subprime mortgage market.¹⁰

5. Credit rating agencies and investors both overlooked the level of risk of complex instruments.¹¹ Page 151

As the FSF explains, the crisis began when poor underwriting standards for subprime mortgages and a weakening of the U.S. housing market led to a rise in delinquencies and a rise in prices for indices based on subprime-related assets. ¹² Leveraged holders of highly-rated products, backed by subprime mortgage assets, took large losses and had to meet margin calls.¹³CRAs downgraded the subprime mortgage-backed structured products.¹⁴These downgrades led investors to lose confidence in the ratings of a wider range of structured assets.¹⁵ In August 2007, money-market investors in asset-backed commercial paper refused to roll over investment in off-balance-sheet products that several banks had set up.¹⁶ Sponsoring banks built up liquid resources to cover the insolvency of the mortgage-backed vehicles.¹⁷Because the devalued mortgage-backed assets devoured banks' liquidity, many banks were unable to provide liquidity to other banks.¹⁸ This liquidity drought led to interest rate increases in the interbank market and a rise in premiums.¹⁹ The reduction in available funding and leverage accentuated the Page 152 subsequent contraction.²⁰ The climate of economic uncertainty in the debt market generated valuation losses in broad asset classes in many countries.²¹Banks were unable to value their own holdings because the disruption to funding markets was lasting longer than many banks' contingency plans had foreseen.²² These events, when taken in compilation, caused an economic panic. Many began calling for international banking and regulatory reform to stop future events like the ones that led to the 2008 economic collapse.

A Banking Supervision and the State of Play Under Basel I

One cannot develop a clear appreciation of the current debate on international banking supervision without a brief background on its evolution and state of play before the U.S. subprime mortgage market's collapse.²³ This brief explanation of how the financial world arrived at the current economic crisis will explain the rules and regulations that aided in the economic collapse.

International agreements addressing banking supervision existed since the late 1970s. The financial turmoil of the late 1970s made clear that markets needed an international approach to banking supervision. The collapse of the Herstatt Bank demonstrated the cross-border implications that the failure of even a mid-sized bank can have on the world economy.²⁴This incident led to the...