The Future of Financial Regulation Vedat Akgiray Chairman, CMB

Story of Finance  Global macro - imbalances  10–15 years of current account surpluses in the east and deficits in the west  In the east: savings > investments  risk-free western government bonds  decreasing real rates (1 – 2 %)  Rapid growth in credit markets (in emerging markets and sectors)  Wild search for higher yields  Financial innovation ( CDO, credit derivatives ……. CDS etc ) CDS volume of $62t in 2008!  Most of “new credit” is within the financial sector ! 2

The Crisis  Did not happen out of nowhere…  In , more than 1,000 S&Ls went under  Enron, Tyco, WorldCom… scandals and bankruptcies  The dot.com baloon and its eventual burst (prices cannot increase all the time!)  LTCM’s failure in 2000 (debt / equity > 25)  Russian, Asian and similar “small” crises  Madoff event (a huge Ponzi scheme managed by 3 accountants!)  There were signals of warning but they were much ignored 3

The textbook says… “It is not from the benevolence of the butcher, the brewer or the baker that we expect our dinner, but from their regard to their own interest.” Adam Smith ( Wealth of Nations ) “Self–interest” + free markets + deregulation = economic welfare 4

Wall Street “ Greed, for lack of a better word, is good. Greed is right. Greed works. Greed clarifies, cuts through, and captures the essence of evolutionary spirit. Greed in all of its forms, greed for life, for money, for love, knowledge has marked the upward surge of mankind…..” Gordon Gekko Greed  self - interest ….. is what we have been teaching for decades 5

A few excerpts “ I hope … that you will find the doctrines of Adam Smith are not to be taken in the form in which your professors are explaining them to you.” J. Robinson (2007) “For it is the irony of the market system that while its very success depends on harnessing the power of self-interest, its very sustainability depends upon people’s willingness to engage in acts that are not self-interested.” L. Summers (2003) “We have always known that heedless self-interest was bad morals; we now know that it is bad economics.” FDR (1937) 6

The non – economics story  Uncalculated greed for more money and success  Both in businessmen and also regulators  Forgotten common sense (“ boşver, bir şey olmaz!” )  “Regulatee” >> Regulator  Comfort of mathematics, models, algorithms etc  “wisdom on vacation” 7

What should we do? 1. Sustainability of maximum self – interest in the long- run sometimes requires short-term sacrifices 2. The probability of “something being wrong” in consistently and continually very high profits is very high  common sense / experience These cannot be ascertained through regulation. At its best, regulation can point to a market mechanism with its own self-discipline. 8

2007 – 09 Lessons for the Regulator  The crisis is not due to lack of regulation, but to poorly designed and enforced regulation  Regulatory gap between public markets and private markets  Regulation shaped by historical crises and not by its own objectives All due to: lack of information, or delayed use of information

Objectives of Financial Regulation  Price stability (via monetary policy)  Financial system stability (management of systemic risks)  Protection of investors and confidence in the financial markets

To – Do List  Reform of corporate governance, making managers accountable and responsible  Managers of all financial institutions / intermediaries  Managers of corporations  Protection of small investors through  Enhanced disclosure and competition  Persuasion to invest in portfolios  Narrow the regulatory gap between public markets and private markets

The New Regulatory System  Enhanced risk management covering not only the financial industry but also using feedback from the real economy  The rules of regulation and supervision should be enforced based on market parameters and triggers (CDS prices, early warning signals, information indexes etc.)  forward-looking regulation  A new architecture where one agency is held responsible for one objective and a board to coordinate these agencies