Risk Management, Responsive Regulation, and Oversight of Structured Financial Product Markets

Globally, regulators, supervisory authorities, and governments are grappling with what have now been identified as systemic risk factors that contributed to the recent global financial crisis. Internationally, the Basel Committee on Banking Supervision and other organizations are developing standards to identify and address systemic risk, suggesting that the extent of regulation or exemption from it can serve as a mechanism by which risk is transferred within the financial system. The Cross-border Bank Resolution Group of the Basel Committee has developed ten recommendations as a result of its stocktaking of lessons learned from the financial crisis.' The Financial Stability Board (FSB), an organization of national financial authorities and international standard-setting bodies, has developed a policy framework for reducing the moral hazard of systemically important financial institutions and for reforming derivatives markets. These initiatives are mirrored by similar initiatives in international organizations, national and regional governments, and a myriad of other regulatory and non-regulatory agencies. The recommendations being developed by government-sponsored international organizations point to three critically important aspects of today's financial markets. First, they are highly globalized, which means that regulation solely by individual states is no longer a sufficient response to the conditions that created the crisis. Financial market players span hundreds of borders, and organize their structures globally for a variety of efficiency, tax-related, liability-related, and other reasons. The interconnectedness of both financial structures and financial products creates tremendous challenges for considering the scope and limits of regulatory oversight. Second, at best, the suggestions generated by these international organizations need to be broad brush strokes, as they operate in a global system in which the type and intensity of regulatory oversight varies considerably. While a need for global standards has been identified, the likelihood of global convergence towards one set of specific standards is slim. Third, there are very diverse regulatory spaces for oversight of financial markets, including state regulators, self-regulatory organizations, and coalitions of business or financial interests that actively pursue their objectives in an array of regulatory spheres. The complexity of the issues, and the regulatory structures that respond to them, pose significant challenges. It is evident that many of the initiatives to date have not addressed the need for a broad-based, participatory public policy debate on the normative objectives that new regulatory requirements seek to achieve. The issues raised by this significant upheaval in the financial system will be the subject of analysis for years to come. On the occasion of John Braithwaite's Fasken Visiting Scholar Lecture and workshop on responsive regulation at the University of British Columbia in 2010, this paper explores a very specific issue among the many raised in respect of regulatory oversight of systemic risk in financial markets. Specifically, it analyses Braithwaite's pyramidal approach to regulatory processes, to assess whether it offers helpful suggestions for the current effort to determine new regulatory standards for the structured financial products market. Derivatives, collateralized debt obligations, and similar products have been viewed as major contributors to the financial meltdown that commenced in 2008. The paper suggests that Braithwaite's model of responsive regulation may have some application, particularly in engaging local citizens in a collaborative policy discussion regarding regulatory oversight. Essentially, Braithwaite advocates a highly dialogic and responsive process in which market participants engage with regulatorsto structure solutions to market problems and create a support structure promoting continuous improvement. He suggests that regulators should not rush to law enforcement solutions before engaging with stakeholders to develop a range of policy responses. However, the effectiveness of Braithwaite's approach is limited by the global nature of these challenges, the intractable nature of private organizations on the global stage in their efforts to resist regulatory change, and profound power imbalances and information asymmetries that would need to be addressed to make such processes more accountable. Part II of the paper sets out the challenge for oversight of structured financial products markets, including the market conditions in respect of such products that contributed to the global financial crisis and the lacuna in regulatory oversight. Part III analyzes the contribution of responsive regulation theory to issues raised by current market conditions. Part IV then suggests that regulatory strategies must address the problems arising out of the crisis, including the moral hazards and the governance issues. Part V assesses the potential contribution of responsive regulation. One issue is that responsive regulation takes time, and there are specific normative principles that could be immediately implemented, as placeholders, to temper the most serious negative distributive harms to market participants. Such principles would guide regulatory responses in the financial services sector and help avoid regulatory capture, if the discourse about regulatory oversight that is an essential aspect of responsive regulation is truly to be meaningful. While the potential exists for more responsive regulation, it is vulnerable to hearing only from the regulated, given the classic problem of organized versus unorganized constituencies and the constraints on their capacity to acquire knowledge, disseminate their views, and influence regulatory change.

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