ETHICS & FINANCIAL REGULATION

KE
1. Role Play as a Financial Sector Regulator who has been asked to set
up an Ethics Task Force in the Industry (cite an area?).

The task force will deal with ethical dilemmas that may confront the
financial sector and advise in establishing ethical guidelines for dealing
with the related issues.

(a) What kind of persons would you look for to fill this position?
(b) What values would you want them to hold?
(c) What types of ethical sensitivity would you be looking for?
(d) What basic ethical principles would you advise the task force to
follow?

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2. Same task described in Role Play 1, but situation applies to the
entertainment (show business) industry

a) What would the differences be?

b) If there are any differences, what conclusions would you draw about
the way we define the morality in this context?

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Reforms Introduced

o Fit & Proper directive (complements corporate governance directive)

o Corporate Governance directive for banks & SDIs

o Mergers & Acquisition directive (minimum requirement to be met for (M&A)

o Implementation of Basel 2/3 standards for counter cyclical capital buffer

o Implementation of IFRS 9
o Capacity building to improve the regulatory framework

o Deposit Insurance Scheme (effective 2019)

o Cyber and Information Security guidelines

o Resolution Office established, etc. 4

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Considerations for regulation in finance industry
• Adverse selection
• Moral hazard
• Insider trading
• Information asymetry
• Fiduciary duty
• Conflict of interest
• Regulatory arbitrage
• Systemic risk
• Herd behavior
The term "363 sale" refers to
a sale of a debtor's assets
authorized under section
363 of the Bankruptcy Code.
Sales of assets under section
363 can range from the sale of
office furniture by a chapter 7
trustee or a sale of
substantially all assets of a
chapter 11 debtor.
 The Role of Regulation in GFC

• The financial crisis was not a

failure of regulation, but a
failure of supervision

• Pressures to deregulate

• The philosophy of Allan

Greenspan and removal of
Brooksley Burns

• Derivatives as “Weapons for

mass destruction”
The Commodity Futures Trading Commission (CFTC) is the federal agency
that regulates trading in derivatives. Things like credit default swaps that
you’ll recognize from the days of the AIG bailout. Those swaps helped drag
the whole financial system to the brink of collapse last year.

There’s a lot of talk lately about coming up with new regulations for the
derivatives market and the CFTC is in the financial news all the time. In the
mid and late 1990s, though, most people didn’t even know the CFTC existed.
They probably didn’t know about the warnings its chairman was giving about
the dangers of derivatives trading. And they almost certainly didn’t know she
was ignored.
In the fall of 2008, the U.S. Congress implemented the Emergency Economic
Stabilization Act as a result of the financial crisis which began that same year.
The Act created the Troubled Asset Relief Program (TARP).

It was the largest component of the government’s measures to address the

subprime mortgage crisis and resulted in expenditures of close to $1 trillion
taxpayer dollars. These “troubled assets” were defined as residential or
commercial mortgages, securities, obligations, or other instruments which in
many cases were utilized for speculative purposes under the banner of
“derivatives.”
Derivatives, also referred to as “futures contracts,” have functioned for
more than 100 years to act as a hedge against fluctuations in prices of items
such as commodities, metals, energy products and financial instruments.
Control of derivatives was insured under the Commodity Exchange Act
(CEA) of 1936, which called for regulation and oversight of derivatives.

Significant growth in the use of derivatives occurred at about the same time
the Federal government decided to deregulate them in 2000 through
passage of the Commodity Futures Modernization Act (CFMA). As a result,
derivative growth along with the simultaneous removal of all controls
associated with them, help lead to the worse financial meltdown in the U.S.
economy in more than 75 years.
Derivatives are viewed by many as complex and murky in nature, however,
they are not new to the financial scene. The early derivatives market began
in the 1860s and consisted of farmers and grain merchants coming together
in Chicago to hedge price risks in such commodities as corn, wheat, soy and
other grain products. This began what came to be known as “futures”
contracts.

The traditional futures contract is an agreement between a seller and a

buyer that the seller will deliver a product to the buyer at a price agreed to
when a contract is first entered and the buyer will accept and pay for the
product at some agreed upon future date. In addition, the buyer has the
opportunity to liquidate some or all of the product prior to delivery.
Although developed initially in the agricultural sector, derivatives quickly
spread into the metals, energy and financial sectors.
The main contentions of the financial school of thought that link derivatives
to the financial crisis lie in the artificial credit boom. The credit expansion
created systematic risk, which led to the use of derivatives as an attempt to
reduce the risk.

The derivatives were traded in a market that lacked transparency, and

proper regulation, i.e., the Over the Counter Market (OTC). In addition,
there is a popular belief that derivatives do not contribute any financial or
economic substance to the general economy but are mere financial
gambling devices. As a result, many arrive at the conclusion that
derivatives do indeed lay at the root of the financial crisis
By the 1980s, a variant of futures contracts was developed, commonly
referred to as “swaps.” They are defined as an agreement between two
parties to exchange a series of cash flows measured by different interest
rates, exchange rates, or prices with payment calculated by reference to a
base amount.

An example of an interest rate swap would be where one party exchanges a

variable rate obligation on an existing loan for a fixed rate obligation. The
expectation is that the fixed rate will be lower than the variable rate.
Thus, instead of buying or selling a single future rate (as would be true
under a traditional futures contract) there now exists the potential for the
“swapping” of commitments. As these complex derivative types took
hold during the 1980s and 1990s the Commodity Futures Trading
Commission (CFTC) granted them exemption from the CEA of 1936.

This caused the number of interest rate swaps, currency swaps, and other
swaps to increase at a significant rate. This culminated in the Commodity
Futures Modernization Act (CFMA) of 2000. Signed into law by President
Clinton, the CFMA removed derivative transactions, from all the
regulatory requirements established in 1936 by the CEA.
Those parties engaging in derivatives were now exempt from capital
adequacy requirements, reporting and disclosure, regulation of
intermediaries, self-regulation, and bars on fraud or manipulation and
excessive speculation.

The Securities and Exchange Commission (SEC) was also barred from
derivatives oversight. Through the passage of this Act lay the seeds for
the destruction that would come in less than a decade. By October, 2008,
the value of the unregulated derivatives market was estimated to be in
excess of $60 trillion. Included in that amount was somewhere close to $30
trillion in credit swaps. At the same time, a perfect storm was developing.
The Federal government was pursuing a course of easy money for
home loans through maintaining low interest rates and providing
Federally-backed less-than-secure home loans. Many of these “sub-
prime” loans became embedded in the $30 trillion of credit swaps.

As a result, when defaults began to occur, they first created a

mortgage crisis, which developed into a credit crisis, which then
turned into a “once in a century” systematic financial crisis that, but
for a huge U.S. taxpayer intervention, may have led in the fall of 2008
to a worldwide devastating Depression.
Although the use of derivatives has become widespread throughout the
U.S. economy over the past 25 years, not all public companies have
engaged in their use. In fact, of the public companies listed in Fortune
500 as of June 1, 2013, only 108 have recorded in their financial notes the
use of such instruments.

As a note, of all the companies accepting TARP bailout monies, 93%

were engaged in the use of some form of derivatives prior to the
inception of TARP. Derivatives were not the only cause of the financial
meltdown, neither were all public companies that engaged in their use
crippled from a financial standpoint. It should be clear that futures
contracts in the form of derivatives must possess some benefit by
shifting risk, otherwise they would not be used at all.
 Given that derivatives have been, and will continue to be used as
instruments that permit the potential minimization of future financial risks,
the question must be asked, “to what extent do they affect the security
price of the firms that utilize them?”

Clearly, if the objective of management is to maximize the return to the

stockholders, some firms may be inhibited from using derivatives if they
are viewed to minimize stock prices. On the other hand, if derivative use
ultimately increases the stock price, more firms would elect their use.
This brief is to assess the role that derivatives play on the security prices of
firms. In particular, do firms that engage in derivative use find that their
change in stock price is significantly different from firms that do not utilize
derivatives?

Specifically, three study periods are assessed;

1) Pre-Crisis period of 2003-2005;
2) Crisis Period of 2008-2010; and
3) Post-Crisis period of 2011- 2013.

A sample of 100 publicly traded firms which accepted TARP funds and
engaged in derivative use is analyzed in all three periods in order to
ascertain any significant differences in stock prices for these firms across
the time periods.
In addition, a sample of 100 publicly traded firms which did not accept
TARP funds and does not engage in derivative use is analyzed in the three
study periods for the purpose of determining any differences in stock
prices. A third sample of 100 firms is also analyzed during the three
sample periods.

These are publicly traded firms which did engage in derivative usage but
were not in peril to the point of accepting TARP funds. The three samples
are then analyzed to assess any differences among them. Findings from
such a comparison might have significant impact to current and potential
investors of firms which engage in derivative instruments.
The loans which eventually turned out to be sub-prime in nature were
bundled together with loans with lesser risk, the risk on the bundle was
underestimated. As a result, mispricing on the bundled rate led to highly
leveraged bets for the holders of such bundles.

The subsequent defaults led to a massive attempt to unwind these

bundles but it was too late from a liquidity standpoint, the effects then
steamrolled and permeated national and international financial markets.
All of this unraveled in a few weeks. Holders of undervalued derivatives
were forced to record current period losses as the swaps took place,
placing downward pressure on earnings and forcing greater securitization.
Given the use, nature, and circumstances that have swirled around
derivative financial instruments, and based on the research undertaken to
date, it becomes even more important to determine the link that derivatives
have to stock prices.

As the Financial Accounting Standards Board (FASB) continues to struggle

to identify what exactly their role should be in the derivatives debate, it is
important to understand the relationship that derivatives have to
stockholder wealth, and stockholder wealth is ultimately dictated by the
price of the stock.
But Greenspan's super-low interest rates and consistent opposition to
regulation of the multitrillion-dollar derivatives market are now widely
blamed for causing the credit crisis. Under Greenspan's tenure the
derivatives market went from barely registering to a $500 trillion industry,
despite billionaire investor Warren Buffett warning that they were "financial
weapons of mass destruction".

Alan Greenspan, chairman US Federal Reserve 1987-2006

Empirical studies suggests that both Warren Buffet and Allen Greenspan
were both correct. When used properly derivatives may be seen to
reduce firm risk, but when used improperly, they could be dangerous and
lead to potential financial ruin.

In addition, investors do not perceive differently firms that use derivatives

(i.e., use them correctly), from firms that do not use derivatives. The
implication of this study is that there are many lessons to be learned from
the Financial Crisis. One big lesson is the proper use of derivatives and
that investors (many of them institutional) are savvy enough to discern
those firms that have an extraordinary ability to utilize derivatives from
those that do not.
The role of credit rating agencies
• Double role: rating securities and advising about trading