Regulating the Financial Markets: Lessons, Challenges, and

Prospects in the Aftermath of the World Crisis

Howard Davies

Director, LSE EFSA

Ewart Memorial Hall

Cairo, 12 December 2010

Five Topics

1. The Financial Stability Board

2. European Regulation

3. Regulation and Markets:

A New Contract?

4. Effective Governance in Financial Firms

5. Financial Sector Pay

1. The Financial Stability Board

The Pre-Crisis Architecture

Global current account imbalances grew rapidly from 2003

Estimates of account balances for selected countries ($ Billion), 1993-2008

Source: The Turner Review: A regulatory response to the global banking crisis. March 2009.

The Post-Crisis Architecture

At a minimum, the FSB should:

- Have a legal personality and a larger staff of its own- Have a full-time chairman- Be the accountability mechanism for the standard-

setters like the Basel Committee and IOSCO, acting on behalf of the G20

- Monitor regulatory changes in individual countries.

2. European Regulation

CoRePerAmbassadors (legislative)

FSC Financial Services

Committee

3L3 Committee

EFCEconomic

and FinancialCommittee

Council of Ministers(ECOFIN)

European Parliament

European CommissionCouncil Working Groups

(legislative)

Government Level

(Finance Ministries +Observers from regulatory level)

ESCEuropeanSecuritiesCommittee

ARCAccountingRegulatoryCommittee

EIOPCEuropean Insurance

and OccupationalPensions Committee

EBCEuropeanBanking

Committee

EFCCEuropeanFinancial

ConglomeratesCommittee

AURCAudit

RegulatoryCommittee

Regulatory Level

(Competent Authorities)

CESRCommittee of

European Securities

Supervisors

CEIOPSCommittee of

European Insurance and Occupational

Pension Supervisors

CEBSCommittee of

European Banking

Supervisors

IWCFCInterim Working Committee on

Financial Conglomerates

EGAOBEuropean Group

of AuditOversight

Bodies

Central Bank Level

Outside CommissionCommittee Framework

ECB

BankingSupervisionCommitteeof the ECB

EU: Pre-Crisis

Macro-prudential supervision

Micro-prudential supervision

Source: De Larosière Report, February 2009.

Members of ECB/ESCB

General Council

European Systemic Risk Board (ESRB)(Chaired by President ECB)

Chairs ofEBA, EIA& ESMA

European Commission

European System of Financial Supervision (ESFS)

European Banking Authority

(EBA)

EuropeanInsurance Authority

(EIA)

EuropeanSecurities and

MarketsAuthority(ESMA)

National BankingSupervisors

National InsuranceSupervisors

National SecuritiesSupervisors

+ +

Information on micro-prudential developments Early risk warning

EU: Post-Crisis

3. Regulation and Markets: A New Contract?

“Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity … are in a state of shocked disbelief.”

Alan GreenspanOctober 2008

“There is growing recognition that the dispersion of credit risk by banks to a broader and more diverse group of investors, rather than warehousing such risk on their balance sheets, has helped make the banking and overall financial system more resilient.

The improved resilience may be seen in fewer bank failures and more consistent credit provision. Consequently the commercial banks may be less vulnerable today to credit or economic shocks.”

IMF Global Financial Stability Report

April 2006

4. Effective Governance in Financial Firms

5. Financial Sector Pay

Relative pay in the financial sector rocketed in the 1990s

Excess wage in the US financial sector relative to non-farm private wage, by type of financial industry

Source: Philippon and Reshef (2009), Wages and human capital in the US financial industry: 1909 – 2006. NBER Working Paper 14644.

The share prices of banks have languished

Source: DigitalLook.com.

Share prices, relative values (May 1999 = 100), May 1999 – Nov 2010

In conclusion, we still have a long way to travel• No central global regulatory authority, with the power to

deliver enhanced regulatory compliance.• EU structures still not adequate for a single financial

market.• No consensus on the new relationship between regulators

and markets, and signs that response to the crisis may produce a new disequilibrium with too large a role for the state.

• Despite a more robust approach to risk management, shareholder engagement is needed to make boards more effective.

• Shareholders must resolve the underlying principal/agent problem reflected in excess pay.

Regulating the Financial Markets: Lessons, Challenges, and

Prospects in the Aftermath of the World Crisis

Howard Davies

Director, LSE EFSA

Ewart Memorial Hall

Cairo, 12 December 2010