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Can the law prevent another financial crisis?


17 December 2008

This is the first in a series of articles written by Philip Wood, Allen & Overy's Special Global Counsel, on the financial crisis and the global slowdown from a legal perspective.  

When things go wrong, especially when they go badly wrong, the legislators' reaction is to demand more rules. The thinking is that rules and decrees and statutes will stop it happening again, ever again. No more failures. All it takes is a flash of the legal wand, the magic of black-letter words on the statute book.

This financial crisis - the worst for nearly 80 years - is no exception. World leaders gathered in Washington on 15 November to propose a new order to make the financial world a safer place. On their agenda, apart from big picture economic moves, they had the anticipated themes – regulatory cooperation, risk management, disclosure, integrity, reforming the multilaterals, securitisations, executive compensation, accounting rules, credit rating agencies and others.

Who's to blame for the bubble?

What we had in this first decade of the twenty-first century was a bubble. The bubble was inflated for all the usual reasons these days - cheap credit, some exciting product thought to be new, lending and borrowing to excess, a collective euphoria. It was inflated by the hot gasses of Greenspan's irrational exuberance, Keynes' animal spirits. Like all bubbles, only a few jeremiads, easily sent packing, expressed forebodings. For the rest - especially homeowners and those with their savings in equities - it was good to get rich for nothing, without actually doing anything.

Like all bubbles, a few canny types got out at the last moment and strolled away, smiling secretly. Nice work. Like all bubbles, everybody else stampeded for the exit at the same time so that the bursting of the bubble was more cataclysmic than it might otherwise have been. No soft landing there.

How the Great Depression shaped the law

The most significant impact on the law came with the Great Depression, a classic bubble. That event engendered the most far-reaching system change of law ever. It generated the entire US regulatory regime which is still with us unchanged in its fundamentals - the Securities Act of 1933, the Securities Exchange Act of 1934, the Trustee Indenture Act of 1939, the others. Only the Glass-Steagall Act, which separated commercial and investment banking, has gone - 70 years later. It also produced the Chandler Act of 1938 which was the precursor to Chapter 11 of 1978.

Elsewhere the Depression impelled insolvency rescue legislation - the Canadian Companies Creditors Arrangement Act, for example, and rescue statutes in Germany and other countries.

So far the present bubble has had a very limited impact on legal systems in terms of fundamental shifts in the law. We have the bank bail-out schemes of course, massive increases in central bank liquidity arrangements, massive extensions of depositor protection. These are all temporary fire-fighting measures. Otherwise there has been some tinkering with the shorting of shares, with mark-to-market accounting rules. The real changes are yet to come.

Why did it happen again?

The background is that over the last ten years or so there has been a torrent of legislation in crucial fields. In the last decade or so, over 50 countries have made major changes to their insolvency legislation - an area at the heart of financial and corporate law. They include North and most of South America, all Europe, most of Asia. Only sub-Saharan Africa and countries in the Middle East have chosen to remain legislatively mute. Over the same period even more countries have installed or adapted their regulatory regimes, including in the Middle East, such as Dubai and Jordan.

The point is that the current legal backdrop is completely different from the Great Depression. Then the world had no regulatory regimes to speak of and, apart from the English scheme of arrangement of 1870 (one of the first reorganisation statutes), little in the way of corporate rescue statutes. Now we have all these things - in colossal abundance so that the towers of law practically bar out the light from the sky.

We have put in place the most astounding array of palliatives the world has ever seen - a fantastically intricate system of regulation, an early warning system via BIS committees, a highly developed set of risk mitigants, such as collateral and set-off and netting. We have insolvency rescue statutes in virtually all important jurisdictions. Yet all this did little to stop the present debacle.

A good example of a collapse having a relatively minor impact on the legal system was Japan of the 1990s. Japan then went through a melt-down as ferocious as this, except that it was confined to one country. Yet Japan saw fit not to make basic changes to its legal system - only a moderate extension of the insolvency rescue statute, some nuances of regulation, a few other things. They must have concluded that it was not the law which was at fault.

Will Basel 2 help?

Can we assert that changes to Basel 2 will really make bubbles a thing of the past? Basel 2 contemplates that banks must have eight per cent of their exposures in capital. If asset prices fall by 50 per cent (which they have), the eight per cent looks pretty puny. Can we lift the capital requirement to make that amount of difference?

Increases of capital increase the cost of credit. Is it possible to introduce transforming liquidity rules for banks which do not question the very idea of banks - that depositors, whether wholesale or retail, get paid now although the assets out of which they get paid cannot be collected now? Banks must have liquidity, i.e. access to deposits and loans.

Is it true that torpedoing securitisations as a source of credit will solve the problem? Securitisations are just a sophisticated form of factoring or discounting of receivables - an idea which has been around since at least Medici's Renaissance.

What went wrong was not that they were so complicated that nobody could understand them - they were actually quite simple. Lots of companies have tiered capital, most companies have much more complicated assets. Many financial assets are sold without the originator holding any of them (said to be one source of the problem) - share and bonds issues, for example. So what's new? What went wrong was straightforward - the assets were bubble assets.

What more can be done?

Can it be that reversing the risk mitigants such as set-off and netting and collateral in the case of failing banks so as to preserve their assets, or giving the executive power to overturn the law, or facilitating bank partial asset transfers will make the crucial difference? The UK government seems to think so in its proposed Banking Bill. It might make things worse - and probably will for British banks and the market generally.

Do we think that introducing conflict of interest policies for rating agencies will ensure that they spot the bubble while everybody else does not? Rating agencies have an almost impossible task. But we need them. Should we have more rules on misselling? We already have yards and yards of those. Is more disclosure the answer? The disclosure we really needed was that we were in a bubble. Do we think that diluting mark-to-market accounting or reducing executive pay will change the world?

Do we believe that everything done so far in our legal systems was a futile inadequate waste? That we can now transform human nature, banish our tendency towards euphoria, optimism and hope, our animal spirits, and our belief that it is possible to get rich for nothing? That we can do this by tinkering here and there, tweaking, promulgating some more rules?

Signs of solidarity

On the economic front, the lessons of the Great Depression have been learnt in how to deal with a crisis like this. There has been an impressive show of international concerted action - $2700 billion in government bail-out funds announced within a month of the Lehmans insolvency - more than the GDP of the UK or France. This was a phenomenal achievement, no small beer. Entirely unexpected, according to the previous consensus which doubted the likelihood of international cooperation on this scale. And despite the mess of the present, the past few years in which this bubble inflated have produced much higher prosperity for billions of people which has not been lost. Which we hope will not be lost.

Regulation: how much is too much?

As for the law and regulation, good things can come of desperate events; the law can be changed for the better, for improvements that are needed. To be sure, we all have a list, for what it is worth. But the history of bubbles shows that the impact on the law can sometimes be adverse. What we now need is to be realistic, level-headed, cool. It is not necessarily right to reach for the legislative sledgehammer. The law has power. But the law can also be another bubble.

When John Law finally got caught out, he observed, " I have made great mistakes... I am only human." If we seek the source of our troubles, all we have to do is look in the mirror.

Financial crisis online service

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These publications are all available within one website and are updated daily. You will also find a list of in-house briefings we can provide to your company.

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Further information

If you have any queries relating to this article, please email Philip Wood or tel: +44 20 3088 2552.

This is the first in a series of articles that Philip will be writing on the financial crisis which will feature on this website.


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