Thought Leadership

Fair-value accounting, also known as “mark-to-market” accounting, has been blamed for contributing significantly to the financial crisis.  But those charges are largely unfounded, according to the study “Did Fair-Value-Accounting Contribute to the Financial Crisis?” by Christian Laux of Goethe University Frankfurt and Christian Leuz of University of Chicago Booth School of Business, which is forthcoming in the Journal of Economic Perspectives, published by the American Economic Association (http://ssrn.com/abstract=1487905).

The Obama Administration’s White Paper on Financial Regulatory Reform is just the beginning of what is likely to be a legislative, regulatory and ideological marathon, despite the Administration's best efforts to achieve domestic political support before its publication. It is far less revolutionary than some either feared or hoped for and reflects an “art of the possible” approach to regulatory reform by the Obama Administration. Ultimately the White Paper reflects a compromise designed to avoid as much as possible the most difficult regulatory, state and congressional turf battles.

Policy coordination between diverse regulatory regimes in financial services ranks highly on the international political agenda because regulatory differences create impediments to growing financial activity. Efficiency-oriented theories fail to explain why coordination was achieved in some domains but not in others, while arguments linking coordination to similarities or differences in states’ substantive policy goals cannot account for coordination progress in spite of vast differences in prior domestic regimes. This Article posits that coordination success or failure depends on the interaction of two variables: whether strong competitors to U.S. firms and markets challenge U.S. dominance and whether activity is centralized at a main facility in a single jurisdiction, such as a stock exchange, or diffused around many separate jurisdictions. Strong U.S. dominance attracts more foreigners to U.S. centralized markets who voluntarily adopt U.S. laws and lobby their governments for policy coordination; yet in dispersed markets, policy coordination offers limited benefits to either the United States or to foreign countries when U.S. dominance is strong.

Two key assumptions underlying the regulation of U.S. financial reporting are the need to
mandate the certification of financial statements, and to require that this certification be
performed by independent auditors.   Private incentives to demand (and supply) certification are
thought to be insufficient, and independence is thought to be necessary for quality audit. In this
study, we collect archival data on certification activity in the economy, and conduct a field
experiment on an unregulated online market for certification of baseball cards to investigate the
validity of these assumptions.

Abstract
A large body of empirical and experimental literature provides convincing evidence of the complexity of individual and institutional investor behaviour in market environments. This complexity raises serious questions regarding the effectiveness of current systems of investor protection regulation, which are largely based on the rational investor model. This chapter considers the whole spectrum of cognitive biases that affect investor decision-making and the impact of investor behaviour on market welfare. It also highlights the failure of current systems of investor protection regulation to devise techniques capable to counter the distorting impact of cognitive biases. In order to enhance the credibility of the behavioural critique, the chapter proposes a realistic and workable framework for reform, which, if implemented, would lead to effective debiasing.

Abstract

There has been substantial public and regulatory attention of late to apparent exploitation of conflicts of interest involving financial services firms based on financial market imperfections and asymmetric information. This paper proposes a workable taxonomy of conflicts of interest in financial services firms, and links it to the nature and scope of activities conducted by such firms, including possible compounding of interest-conflicts in multifunctional client relationships. It lays out the conditions that either encourage or constrain exploitation of conflicts of interest, focusing in particular on the role of information asymmetries and market discipline, including the shareholder-impact of litigation and regulatory initiatives. External regulation and market discipline are viewed as both complements and substitutes – market discipline can leverage the impact of external regulatory sanctions, while improving its granularity though detailed management initiatives applied under threat of market discipline. At the same time, market discipline may help obviate the need for some types of external control of conflict of interest exploitation. JEL G21, G24, G28, L14. Keywords: Conflicts of interest.  Financial regulation. Financial services. Banking.

ABSTRACT

The implementation of the European Union’s Action Plan for Financial
Services (“FSAP”) is largely complete, though the transposition of
relevant legislation into the Member states’ legal orders is still pending.
The new legislation has significantly revamped the EU’s legal and
regulatory framework governing financial markets. The Lamfalussy
process has been successfully utilized in debating and enacting the most
important pieces of the new EC securities legislation. This article
provides a critical analysis of the securities Directives passed under
FSAP and critically evaluates their impact on EU capital markets and the
EU financial services industry. Furthermore, this article sheds light on
the evolution of EC financial market regulation and on the most
important and intricate points of the new legislation. It explains the
reasons that make the new legislation an agent of profound change for
EU financial markets in terms of structure, business planning and trading
processes. Finally, the article debates the cost of compliance with and
enforcement of the new framework and the supervisory and enforcement
loopholes created due to the absence of a single regulator for EU
financial markets.

INTRODUCTION

The recent history of banking and finance has seen tremendous growth in the size
of banks and other financial institutions as well as in the speed and complexity of their
operations. Increasing attention has been rightly focused on ensuring effective
supervision, risk management, operational resiliency, and international supervisory
cooperation in order to address the challenges posed by larger banks. Despite great
improvements in these areas, however, the past twenty years have seen repeated financial
crises across the globe often triggered or accompanied by instability in large banks.

Fair value accounting, introduced formally in 1993 by the Financial Accounting Standards Board (FASB), was intended to make financial statements easier to compare and balance sheets more reflective of real values. Instead, as applied by accountants in the current credit crunch, it has been the principal cause of an unprecedented decline in asset values and an unprecedented rise in instability among financial institutions. The system has to be rethought, not only because of its contribution to financial instability but also because its procyclicality tends to create asset bubbles and exacerbate the effects of their collapse.