UNI Private Equity Group Global Campaign for Private Equity Accountability Re-regulation in the aftermath of the financial crisis Nyon, 10 November 2008

UNI Private Equity Group

Global Campaign for Private Equity Accountability

Re-regulation in the aftermath of the financial crisis

Nyon, 10 November 2008

The crisis Unsustainable model of growth The ‘structured finance’ business and the illusion of risk spreading Investment banks, conglomerates and the cost of regulatory arbitrage Shareholder value model of corporate governance versus market integrity

Unsustainable model of growth

The ‘structured finance’ business and the illusion of risk spreading

Investment banks, conglomerates and the cost of regulatory arbitrage

Shareholder value model of corporate governance versus market integrity

The crisis Unsustainable model of growth The ‘structured finance’ business and the illusion of risk spreading Investment banks, conglomerates and the cost of regulatory arbitrage Shareholder value model of corporate governance versus market integrity Wage compression Predatory lending & debt-financed consumption Transfer of pension market risks onto workers

Unsustainable model of growth

The ‘structured finance’ business and the illusion of risk spreading

Investment banks, conglomerates and the cost of regulatory arbitrage

Shareholder value model of corporate governance versus market integrity

Wage compression

Predatory lending & debt-financed consumption

Transfer of pension market risks onto workers

The crisis: un-regulated products “ originate and distribute” model of credit default risk Lack of regulation no standardisation No supply/demand price fixing credit rating agencies. self-feeding asset depression process ‘ pro-cyclical’ accounting rules rigid prudential rules Unsustainable model of growth The ‘structured finance’ business and the illusion of risk spreading Investment banks, conglomerates and the cost of regulatory arbitrage Shareholder value model of corporate governance versus market integrity

“ originate and distribute” model of credit default risk

Lack of regulation

no standardisation

No supply/demand price fixing

credit rating agencies.

self-feeding asset depression process

‘ pro-cyclical’ accounting rules

rigid prudential rules

Unsustainable model of growth

The ‘structured finance’ business and the illusion of risk spreading

Investment banks, conglomerates and the cost of regulatory arbitrage

Shareholder value model of corporate governance versus market integrity

“ originate and distribute” model of credit default risk spreading risks mitigates risks, reduces the cost of capital and therefore enhances economic growth hiding increases increases kills revisited Bankers made money on way up but didn’t lose on the way down Credit Rating agencies were paid to give over-optimistic ratings

spreading risks

mitigates risks,

reduces the cost of capital

and therefore

enhances economic growth

Notional amounts of OTC derivatives outstanding (US$bn)

The crisis: lightly-regulated institutions deposit banking vs shadow banking blurring of the lines, off-balance sheet operations regulatory gaps & arbitrage within groups between jurisdictions risk management becomes an oxymoron Too big to fail, be saved be supervised Unsustainable model of growth The ‘structured finance’ business and the illusion of risk spreading Investment banks, conglomerates and the cost of regulatory arbitrage Shareholder value model of corporate governance versus market integrity

deposit banking vs shadow banking

blurring of the lines, off-balance sheet operations

regulatory gaps & arbitrage

within groups

between jurisdictions

risk management becomes an oxymoron

Too big to fail,

be saved

be supervised

Unsustainable model of growth

The ‘structured finance’ business and the illusion of risk spreading

Investment banks, conglomerates and the cost of regulatory arbitrage

Shareholder value model of corporate governance versus market integrity

Deposit banking vs shadow banking Source: IMF, October, 2008, via Crotty & Epstein 2008

Source: IMF, October, 2008,

via Crotty & Epstein 2008

The crisis Imperial CEOs Weak risk management Compensation & golden parachutes Lying to the markets to protect shareholder value "Free cash flow” given back to shareholders is now badly missing Unsustainable model of growth The ‘structured finance’ business and the illusion of risk spreading Investment banks, conglomerates and the cost of regulatory arbitrage Shareholder value model of corporate governance versus market integrity

Imperial CEOs

Weak risk management

Compensation & golden parachutes

Lying to the markets to protect shareholder value

"Free cash flow” given back to shareholders is now badly missing

Unsustainable model of growth

The ‘structured finance’ business and the illusion of risk spreading

Investment banks, conglomerates and the cost of regulatory arbitrage

Shareholder value model of corporate governance versus market integrity

The cost of corporate short-termism *purchased by BoA for 50bn; ** purchased 1.2bn by JP Morgan Chase following offloading of toxic assets valued at 29bn onto US gvt; *** 2007 only; **** entered into bankruptcy on 15 sep 5.3 4 Lehman Brothers**** 7.1 5 Morgan Stanley 1.7 1.7 1 Bear Stearns ** 8.2 12.1 25 JP Morgan Chase 11.8 16.8 10 Goldman Sachs 5 7.8 25 7.5 Citigroup 2.2 14.4 1.2 8 Merril Lynch* 1.3 17.5 25 Bank of America Debts to executives Buy-Backs 2006-07 US gvt injection Other funds Non-OECD SWF

The management of the crisis Unsustainable model of growth The ‘structured finance’ business and the illusion of risk spreading Investment banks, conglomerates and the cost of regulatory arbitrage Shareholder value model of corporate governance versus market integrity Central banks did not prevent the bubble (but knew it would happen) Self-market correction did not happen Weak national & international governance Regulatory catch-22

Unsustainable model of growth

The ‘structured finance’ business and the illusion of risk spreading

Investment banks, conglomerates and the cost of regulatory arbitrage

Shareholder value model of corporate governance versus market integrity

Central banks did not prevent the bubble (but knew it would happen)

Self-market correction did not happen

Weak national & international governance

Regulatory catch-22

Re-regulation Unsustainable model of growth The ‘structured finance’ business and the illusion of risk spreading Investment banks, conglomerates and the cost of regulatory arbitrage Shareholder value model of corporate governance versus market integrity Central banks did not foresee the bubble Weak economic & financial governance

Unsustainable model of growth

The ‘structured finance’ business and the illusion of risk spreading

Investment banks, conglomerates and the cost of regulatory arbitrage

Shareholder value model of corporate governance versus market integrity

Central banks did not foresee the bubble

Weak economic & financial governance

Re-regulation Strengthening financial safeguards & international cooperation Diversifying finance & Protecting social development goals Spreading responsibility throughout the investment chain Unsustainable model of growth The ‘structured finance’ business and the illusion of risk spreading Investment banks, conglomerates and the cost of regulatory arbitrage Shareholder value model of corporate governance versus market integrity Central banks did not foresee the bubble Weak economic & financial governance

Strengthening financial safeguards & international cooperation

Diversifying finance & Protecting social development goals

Spreading responsibility throughout the investment chain

Unsustainable model of growth

The ‘structured finance’ business and the illusion of risk spreading

Investment banks, conglomerates and the cost of regulatory arbitrage

Shareholder value model of corporate governance versus market integrity

Central banks did not foresee the bubble

Weak economic & financial governance

Re-regulation Unsustainable model of growth The ‘structured finance’ business and the illusion of risk spreading Investment banks, conglomerates and the cost of regulatory arbitrage Shareholder value model of corporate governance versus market integrity Central banks did not foresee the bubble Weak economic & financial governance Strengthening financial safeguards & int’l cooperation Ensure fair prudential regulation for banks Review the mandate and public accountability of central banks Reign in int’l flows of capital Offshore Financial Centres Staffing of supervisory and enforcement authorities (Protecting social development goals) (Spreading responsibility throughout the investment chain)

Unsustainable model of growth

The ‘structured finance’ business and the illusion of risk spreading

Investment banks, conglomerates and the cost of regulatory arbitrage

Shareholder value model of corporate governance versus market integrity

Central banks did not foresee the bubble

Weak economic & financial governance

Strengthening financial safeguards & int’l cooperation

Ensure fair prudential regulation for banks

Review the mandate and public accountability of central banks

Reign in int’l flows of capital

Offshore Financial Centres

Staffing of supervisory and enforcement authorities

(Protecting social development goals)

(Spreading responsibility throughout the investment chain)

Re-regulation Unsustainable model of growth The ‘structured finance’ business and the illusion of risk spreading Investment banks, conglomerates and the cost of regulatory arbitrage Shareholder value model of corporate governance versus market integrity Central banks did not foresee the bubble Weak economic & financial governance (Strengthening existing safeguards and international cooperation) Diversifying finance & protecting social development goals Protect households against predatory lending Diversifying the financial sector & support community-based financial services Protect workers’ pension schemes International taxation (Spreading responsibility throughout the investment chain)

Unsustainable model of growth

The ‘structured finance’ business and the illusion of risk spreading

Investment banks, conglomerates and the cost of regulatory arbitrage

Shareholder value model of corporate governance versus market integrity

Central banks did not foresee the bubble

Weak economic & financial governance

(Strengthening existing safeguards and international cooperation)

Diversifying finance & protecting social development goals

Protect households against predatory lending

Diversifying the financial sector & support community-based financial services

Protect workers’ pension schemes

International taxation

(Spreading responsibility throughout the investment chain)

Re-regulation Unsustainable model of growth The ‘structured finance’ business and the illusion of risk spreading Investment banks, conglomerates and the cost of regulatory arbitrage Shareholder value model of corporate governance versus market integrity Central banks did not foresee the bubble Weak economic & financial governance (Strengthening existing safeguards and international cooperation) (Protecting social development goals) Spreading responsibility throughout the investment chain Reform the credit rating industry Regulate credit risk transfers and derivatives Regulate private investment funds and conglomerates Ensure executives’ and intermediaries’ perverse incentives are reversed Combat corporate short-termism

Unsustainable model of growth

The ‘structured finance’ business and the illusion of risk spreading

Investment banks, conglomerates and the cost of regulatory arbitrage

Shareholder value model of corporate governance versus market integrity

Central banks did not foresee the bubble

Weak economic & financial governance

(Strengthening existing safeguards and international cooperation)

(Protecting social development goals)

Spreading responsibility throughout the investment chain

Reform the credit rating industry

Regulate credit risk transfers and derivatives

Regulate private investment funds and conglomerates

Ensure executives’ and intermediaries’ perverse incentives are reversed

Combat corporate short-termism

Re-regulation & private equity Financial safeguards & int’l cooperation Prudential regulation for banks CB mandate and public accountability International flows of capital Offshore Financial Centres Staffing of financial authorities Diversifying finance & social goals Protect households Community-based financial services Protect pensions International taxation Spreading responsibility Credit rating industry Credit risk transfers and derivatives Private funds & conglomerates Executive compensations Corporate short-termism

Financial safeguards & int’l cooperation

Prudential regulation for banks

CB mandate and public accountability

International flows of capital

Offshore Financial Centres

Staffing of financial authorities

Diversifying finance & social goals

Protect households

Community-based financial services

Protect pensions

International taxation

Spreading responsibility

Credit rating industry

Credit risk transfers and derivatives

Private funds & conglomerates

Executive compensations

Corporate short-termism

Crotty & Epstein 2008 A regulatory precautionary principle for new products and processes created by financial innovation Once the financial regulatory structure is extended to all important financial institutions, similar to the US Food and Drug Administration to determine whether new drugs should be allowed on the market. Innovation in the financial sector is not like innovation in goods Has broad “externalities” and links to systemic risk Systemic risk that are not taken into account by innovators A 180° shift in the regulatory approach Ensure overlaps, redundancies, multiple firewalls

A regulatory precautionary principle for new products and processes created by financial innovation

Once the financial regulatory structure is extended to all important financial institutions,

similar to the US Food and Drug Administration to determine whether new drugs should be allowed on the market.

Innovation in the financial sector is not like innovation in goods

Has broad “externalities” and links to systemic risk

Systemic risk that are not taken into account by innovators

A 180° shift in the regulatory approach

Ensure overlaps, redundancies, multiple firewalls

[email_address] +33 1 55 37 37 38

[email_address]

+33 1 55 37 37 38