This panel was convened at 10:45 a.m., Friday, March 26, by its moderator, Anupam Chander of University of California, Davis School of Law, who introduced the panelists: Robert B. Ahdieh of Emory University; Donald C. Langevoort of Georgetown University Law Center; Barbara C. Matthews of BCM International Regulatory Analytics LLC; and Joel Trachtman of Tufts University. *
* Donald Langevoort served as an expert commentator on the remarks of the other panelists, but has yielded his space here in order to allow others more room to publish their remarks.
INTRODUCTORY REMARKS BY ANUPAM CHANDER ([dagger])
Few countries can afford autarky in finance--financing all capital investments through domestic sources, and investing only locally. Finance thus creates a web of global interconnection. At its best, this web directs capital to the parts of the world that can use it most efficiently, powering infrastructure development, research, and employment. At its worst, it can transmit financial turmoil from one jurisdiction across the globe.
Having been the breeding ground of the financial crisis that engulfed the world at the end of the first decade in the twenty-first century, the United States is now seeking to put its own financial house in order. Senator Chris Dodd has recently introduced the Restoring American Financial Stability Act--a comprehensive, top-to-bottom reform of the financial system, seeking to ensure that regulators anticipate systemic vulnerabilities.
But because of the international web of finance, this may not be enough. Even if we perfect our own financial regulation, we can still be buffeted by systemic financial failures elsewhere--just as others can be buffeted by crises created here. Given this web of interconnected finance, many have argued that countries must coordinate their financial regulation. Coordination reduces the possibility of regulatory arbitrage, where companies seek lightly regulated havens from which to provide services across the world. But coordination reduces the possibility of competition, along with the natural laboratories that regulatory variation across the world would offer.
The decision to compete or cooperate will vary over time and subject matter. In a recent paper, Randall Costa and I traced the evolution of the regulation of credit derivatives over the last decade, from competition to coordination) At the end of the 1990s, fear of losing the derivatives markets to London helped spur Congress to deregulate that market here. A decade later, faced with the debris of the 2008 financial crisis, regulators on both sides of the Atlantic reconsidered their laissez-faire attitude. Regulators in Brussels and Washington converged on a single solution--central counterparty clearing. They did so largely out of recognition that a central counterparty clearinghouse (CCP) would "reduce the risk that the bankruptcy of a principal in a credit default swap would precipitate a domino fall through the credit markets." (2) Arriving largely independently at this conclusion, regulators recognized that cooperation in implementing the CCPs had some important virtues. For example, if the Europeans exempted corporate end-users of derivatives from the CCP requirement, then American corporations might shift their transactions to Europe. The American regulators argued, "International coordination is essential to ensure comprehensive regulation of the OTC derivatives markets. We must not leave gaps in our regulatory structure that allow traders to evade one country's regulations by taking their business elsewhere." (3)
Remarks from panelists Robert Ahdieh, Barbara Matthews, and Joel Trachtman will offer important guidance as to the virtues and prospects for coordination or competition in global finance.
([dagger]) Professor of Law, University of California, Davis School of Law.
(1) Anupam Chander & Randall Costa, Clearing Credit Default Swaps: A Case Study in Global Legal Convergence, 10 CHI. J. INT'L L. 639 (2010).
(2) Id. at 640.
(3) Id. at 682 (citing statement of Gary Gensler, Chairman of the Commodities Futures Trading Commission).
CRISIS AND COORDINATION: REGULATORY DESIGN IN FINANCIAL CRISES
As we slowly move beyond the most significant financial crisis the world has faced since the Great Depression, its long-term consequences for our social, economic, and even political life are gradually becoming clear. Beyond the striking breadth and depth of this crisis, meanwhile, the frequency of financial crises is generally on the rise. As the last few years have made evidently clear, however, our understanding of how to handle such crises is woefully limited. In the absence of financial panic, we are unsure what to do to prevent it. Once it arises, we are nearly as unsure what to do to alleviate it.
Our uncertainty, meanwhile, operates at two levels: First, as to matters of substantive policy, and second, as to questions of institutional design. As to the first, what policy choices can be expected to maximize the ongoing stability of global financial markets? As to the second, what regulatory structures and institutions are likely to be most effective in preventing and alleviating financial crises?
To get at these issues, we need to begin with a more foundational question: What is the root cause of financial crises? Recent years, of course, have seen a great deal of discussion of this question. For the most part, however, it has not occurred at the level of generality necessary to offer a framework for the design of substantive policy, let alone to resolve questions of institutional design. Equally striking has been the disconnect between our discussion of potential causes of the recent crisis, and much of our analysis of appropriate regulatory responses. Our assessment of potential responses to the crisis, thus, has often been unmoored from any theory of causation--whether of the recent crisis or of financial crises more generally.
In my brief remarks today, I hope to convince you that the genesis and persistence of a financial crisis, as opposed to economic or financial turmoil more generally, should not be understood as an issue of sub-prime mortgages, asset securitization, inadequate risk regulation, the failures of credit rating agencies, or any of the other familiar targets in recent debates. Rather, financial crises originate from the systemic nature of risk and reward in certain sectors of the economy, from consequent interdependence in the behavior of market participants, and from the resulting tendency of relevant markets to tip abruptly and strongly between alternative equilibria. Rather than one or more of the standard causes discussed, it was the presence of multiple equilibria in financial markets that stood at the center of the recent crisis. Failures of lending, asset securitization, risk, and the like may well be predicates to the emergence of crisis--or at least the recent crisis. Our efforts to define an appropriate regulatory response to financial crises go astray, however, when we focus on these phenomena as causes. Rather, it is the presence of multiple equilibria--and resulting challenges of coordination--that should be our focus.
In multiple equilibrium settings, including the financial markets, the Internet, standard-setting processes, and technological innovation, among others, relevant actors are faced with more than one stable set of strategies, from which no individual has an incentive to deviate, absent a change in strategy by their counterparts. Thus, in the classic metaphor of coordination among multiple equilibria, two or more drivers can choose to drive either on the right or on the left--and none can be expected to change sides, unless they expect other drivers to do so as well. This is likewise the dynamic at work in standard-setting and network environments, including in the choices between VHS versus Betamax video recorders, Blu-ray versus HDDVD players, and various alternative protocols for Internet file transfers. Once a given standard (or equilibrium) has emerged, all are incentivized to embrace it--and to maintain it.
In many areas of finance, something similar can be observed. Consider the classic bank run: the most conventional manifestation of financial crisis, and the case study for early models of multiple equilibria in financial markets. As modeled by economists Douglas Diamond and Philip Dybvig, the critical characteristic of bank runs is the presence of multiple equilibria. (1) In the preferred equilibrium, a depositor places her funds with the bank, confident in her ability to withdraw them on whatever future date she can make optimal use of them. This allows other depositors to withdraw on earlier (optimal) dates, thereby generating an efficient distribution of risk. In the inferior equilibrium, by contrast, confidence in the behavior of other depositors is undermined, causing all depositors to seek immediate (and sub-optimal) withdrawal of their assets--and thereby breaking the bank. The essential dynamic of modern banking, as such, is one in which coordination of depositors around an equilibrium of "maintain deposits" generates optimal returns, while coordination around an equilibrium of "withdraw deposits" breaks the bank--and perhaps the economy generally.
This multiple equilibrium dynamic is not unique, however, to banks or bank runs. Rather, it is characteristic of the financial markets more generally--if not inherently, at least in their modern forms. The day-to-day operation of today's financial markets thus involves a significant degree of interconnection and coordination. The returns on investment to any given individual, meanwhile, are often keyed to its attraction to others. The result? Again, a multiple equilibrium dynamic, in which market participants' move largely in tandem, embracing either the efficient equilibrium of lending and investing, or an inefficient (but shared) resistance to doing so.
Once we appreciate...