When Politics and Markets Collide

As the world emerges from the worst recession since the Great Depression, a new financial landscape is beginning to take shape. The shortcomings of the financial sector not only shocked and angered the general public, but resulted in a level of government intervention in the financial sector not seen since the end of the Second World War. This widespread acknowledgement that financial markets are not self-equilibrating, has shifted the boundary between politics and the financial industry – the two have now started to merge.

This shift emerged as the excesses of the financial sector, frustration with the opaque nature of many financial transactions, not to mention unmerited bonuses, entered the political battleground. Unquestionably, the extensive monetary interventions by central banks as well as fiscal policy actions and bail-outs by governments have demonstrated the crucial role played by the public sector in combating the deepest global recession since the 1930s. In order to avoid the repetition of past mistakes, the financial sector needs to adopt new standards of governance, particularly enhanced regulation, greater transparency, and a heightened sense of responsibility.

Out of the severe economic crisis a global consensus has emerged for the need for more extensive oversight. This has not, however, meant an agreement on its extent or whose responsibility will be to enforce it. In a statement after the Pittsburgh summit, the G20 leaders expressed a firm desire “to make sure our regulatory system for banks and other financial firms rein in the excesses that led to the financial crisis”. The proposed measures of raising capital standards, implementing international standards of remuneration, improving over-thecounter derivatives markets and introducing more controls over large financial firms, require broad international coordination. Despite widespread national and international support, finetuning and implementing these measures is proving to be a major political power struggle.

In December 2009 the European Union member states reached a compromise deal concerning financial regulation. Three new EU supervisory authorities – in banking, insurance and securities sectors – will be created to cushion the destabilising effects of finance. As expected, Britain was anxious to protect the City of London’s role as a major financial hub and therefore reluctant to cede oversight of financial services to Brussels. The City does not want its power undermined by other EU states, most notably by France, which succeeded in securing the appointment of Michel Barnier, a former French agriculture and foreign minister, as the new EU finance minister. Consequently, the resulting agreement of complex voting and appealing procedures means that the primary responsibility for regulation continues to rest with national regulators. This political arm wrestling between France and Britain may well safeguard national sovereignty instead of promoting European-wide cooperation in a future crisis.

On the other side of the Atlantic, the role of the Federal Reserve has come under scrutiny in the political discussions on financial governance. Many wish to subject the Fed to audits by the Government Accountability Office, while others want to strip the Fed of its power to regulate banks. After years of relatively little regulation, the Congress is debating the most important overhaul of the industry since the New Deal on issues ranging from executive remuneration and transparency for derivative trades to new powers for federal regulators to break up companies deemed “too big to fail.” It is reasonable to assume that as a result Wall Street will lose some of its autonomy and its actions will be more carefully inspected.

In addition to regulation, most commentators emphasise the need for greater transparency in the financial system. This is most apparent in the derivatives market, characterised by opaque over-the-counter transactions and high risk taking. The Obama administration and the European Commission argue for the introduction of clearing houses to reduce counterparty risk and to improve the visibility of trades. Moreover, politicians argue that greater transparency will reduce risk taking in general in the clouded derivatives market, and with any luck, enable early detection of future financial crises.

Many hope that enhanced transparency will breed a new type of responsible investing. Visibility and coherency in the use of complex financial instruments will reduce excessive risk taking, standardise transactions, and hence bring order to the esoteric world of finance. Steps in this direction have been taken in the Hedge Fund space with the use of UCITS III Funds, which are regulated, liquid and transparent versions of their opaque and highly illiquid close relatives, the traditional hedge funds. As the trend towards more regulated UCITS III funds demonstrates, it is likely that the post-Lehman investors will look for stability, consistency and accountability over above-average returns in their investment strategy. In the same way that the political sphere needs to be transparent and accountable, the financial sector needs similar checks and balances in order to promote a new mentality in investing.

The question of responsibility is multi-layered. Many agree that governments, the EU, ECB, the Fed, and other regulatory bodies need to play a greater role in national and international economic and financial governance. However, it can equally be argued that it is as much of an individual as it is a collective responsibility to debate the role and actions of the financial sector even outside times of crisis. Even more importantly, it is the responsibility of financial institutions themselves to promote a culture of accountability and adhere to ethical standards. Unless the change comes also from inside the industry, the role of the regulators will remain marginal. This debate will certainly continue in the coming years as the political impact of unemployment, increasing tax burdens and burgeoning government budget deficits will shape the financial landscape even as market conditions continue to improve.

After a difficult two years there is light at the end of the tunnel, and as the public uproar subsides, company balance-sheets appear healthier and investor confidence starts to return, many in the financial sector hope for a return to ‘business as usual’. However, the recent financial scares from Greece and Dubai should act as a reminder of the fragility of the financial system and the long and painful road of de-leveraging ahead. Crucially, it is important to recognize that this crisis is also an opportunity to recreate an industry that serves a wider interest. And the best way to remind ourselves of this is by encouraging continuous dialogue between politics and finance.