Insecurity and collusion in international finance: The failure of regulation and the visible hand of self-preserving finance

Conflict, cooperation and security, are key terms not only in international affairs, but also in international finance. Conflict is a well-defined term often linked directly to market competition between a multitude of actors in international finance. With the dissolution of borders and internationalisation of capital combining with a continual lack of international regulation of the banking and financial sectors in recent years, the market has become increasingly more insecure.

Amid the impotence of regulators to stabilise international finance, large economic firms have begun to find their own means to secure economic survival by initiate a surprising level of collusion and cooperation between themselves. This attempt to create their own version of a self-correcting market, their own visible hand, is evident by a number of recent events where large financial actors operating in largely unregulated competitive environments, fear the transmitting of economic failure across financial networks. The colluding shift towards establishing cartels and oligarchic practices is increasingly becoming preferable to obtain financial security, even at the cost of sacrificing competition in today’s financial system.

Market insecurity

As the 2007-2008 financial crisis has demonstrated, the global economy is full of risk and insecurity. The intensification of globalisation and its associated growth of international markets highlight that economic distortions in one country can be transmitted through the overgrown financial system across the globe, where they can have devastating implications even on fairly developed countries. As concluded by the Lancet report (Kentikelenis et al, 2011), the economic depression in Greece has had severe effects on its population, causing many social upheavals. Put simply, the increased complexity and interconnectedness of the economic system has facilitated a quick transmission of financial shocks to the entire economy (Hasman, 2013). The insecurity here in question is, however, not of states or individuals, but of large financial institutions, as those hold the vast economic power globally.

The moment that we are experiencing now is the post bubble-burst period, where the State needs to return and regulate finance, giving priority to the “new and renewed production capital [the ICT], which can then lead the expansion using the installed potential for growth and innovation” (Perez, 2010, p.3). Finance, however, has overstayed its welcome and created a vast amount of unsound wealth, which has to be dealt with.

As reported by the Bank for International Settlements (BIS, 2007), prior to the crisis in 2007, over-the-counter contracts amounted to over $516 trillion (from $234 in 2005), while the global GDP at purchasing power parity was estimated at only $66 trillion. Thus, the real economy formed only about one eight of global wealth.

This fairly unlimited expansion of credit was facilitated by a fairly new occurrence in international finance; shadow banking. This new financial structure creates liquidity with very high efficiency through the use of innovative financial products (Paraschiv & Qin, 2013). The size of this system reached almost $20 trillion by 2008, significantly exceeding the liabilities of the traditional banking system (Figure I).

Figure I

Source: Pozsar et al (2010)

In terms of the recent financial crisis, prior to the collapse of large investments banks (e.g. Lehman Brothers or Bear Stearns), the shadow banking system collapsed first. The size of shadow banking combined with lax regulation and the lack of tools for regulators and supervisors to restructure the failing banking system, aggravated the financial crisis and exacerbated its outcome (Marinc & Razvan, 2011). Thus, when the bubble burst in 2007, shadow banking collapsed and quickly spread to the rest of the global economy and to countries like Greece, where it caused massive social disruptions and deterioration of the quality of life. Adam Smith’s invisible hand went too far.

Unable to regulate

The crucial problem here is that despite this evident dysfunction, policymakers remain largely incompetent to address and regulate shadow banking and international finance in general. There are two reasons for this. Firstly, aiming to promote their global competitiveness, national governments are reluctant to independently implement regulation on their respective territories, as it may result in driving businesses away (Dore, 2008). Thus, this race is still to (and at) the bottom. Secondly, there is a lack of consensus on the international arena. Even in a fairly centralized and cooperative organisation such as the European Union, nation states are reluctant to relegate national regulatory powers to this supranational entity (Spenzdharova, 2012). The only effective regulator that remains in place is fear of another collapse. Large financial institutions are fully aware of this.

Governments’ efforts to coordinate and devise working global regulatory frameworks are a slow and painful process. Moreover, there is a lot of variance, inconsistency, and postponement in implementing the new regulatory framework known as Basel III across the international arena. What is more, even when new regulatory measures are implemented, they tend to undermine banks’ ability and motivation to conduct business across borders (Economist, 2013). In other words, the new financial regulation coming from Switzerland is hurting banks and by implication the global economy as well (Financial Post, 2013). This forces banks to seek other ways of profit, what is imperative for securing their survival on the market.

Furthermore, some begin to question whether financial reform has worked at all? Banks are getting bigger as the derivative trading has risen to over $700 trillion, while the global GDP has remained almost the same (Denning, 2013).

In sum, banks are not being effectively regulated, yet they find ways to profit. The banks’ solution to this conundrum is that collusion and cooperation among banks are taking over from the desired market competition. As in any other capitalist market, competition is beneficial for the banking system as well (Hasan & Marinc, 2013), yet it is currently becoming largely absent. This was most evident during the LIBOR scandal.

The reason why the absence persists lies in firstly historicizing this claim. Then we can enrich and complete it by stating that it applies only during the years of prosperity, and more importantly, it applies in the long run. This specifically relates to large multinational banks in times of economic recessions, where competition becomes costly (Vives, 2010) and causes an increase in risk-taking. This could have negative effects even on the winners of such competition. In other words, competition among banks during recession could result in bankruptcy of the loser(s) of such competition, for it would create distrust on the market, drying out of credit, and subsequently dragging under other market participants as well.

As a result, under the present situation the rational choice for banks seems to be collusion. Putting this in the words of illustrative game theory, cooperation (collusion) for both players becomes Nash equilibrium and Pareto optimal solution. As shown on the example below, collusion is beneficial for both banks.

Simple two-person game (two banks colluding)

Bank 2

Collude

Compete

Bank 1

Collude

1, 1

0, -1

Compete

-1, 0

-1, -1

Although such move is strictly opposed by market watch dogs (such as the European Commission or the Bank for International Settlements), currently it seems to be the best option that secures some growth and does not threaten economic fragility. The following examples are evidence of the above claims.

In October 2011, an evidence of post-crisis cooperation came when the European Commission investigated financial institutions that were holding derivatives linked to EURIBOR. Subsequently, in June 2012, the US and UK authorities fined Barclays Bank for manipulating EURIBOR and LIBOR benchmark rates. As admitted by Bob Diamond, Barclays chief executive, “the bank made a conscious decision to falsify Libor rates in order to protect the banks at the height of the financial crisis” (Telegraph, 2012). In other words, the visible hand of the bank corrected the market in its favour.

Barclays was not the sole winner, though. The authorities have been investigating more than 20 international banks that benefited from the LIBOR rigging. Most recently, Fannie Mae decided to sue nine of the world’s largest banks for manipulating LIBOR (Reuters, 2013).

Another example comes from December 2012, when the Swiss UBS AG was fined for having its traders collude with interdealer brokers as well as for manipulating benchmark rates. This collusion allowed the UBS to increase their profits (FSA, 2012).

Recently, Hungarian authorities have fined 11 banks, almost all units of large multinational banks, over colluding in an illegal mortgage cartel. The government legislation against which these banks colluded forced them to accept repayments of foreign-currency loans under the actual market rates (Bloomberg, 2013).

Clearly, a temporary cartel appears to be the means for temporarily securing prosperity on the financial markets, even at the cost of sacrificing competition and creating oligarchic edifices. Banks chose not to compete in order to secure mutual benefits and to avoid driving their competitors to bankruptcy, which could trigger contagion and bank runs, leading to their own demise (Hasan & Marinc, 2013).

Furthermore, despite the explicit prohibition of banking cartels, a number of implicit cartels could have occurred as well. Although the aim is to use government support to limit unfair competition, conduct limitations such as market-share restrictions or price caps can indeed impede competition. In particular, as a response to such measures, ‘competing’ banks jointly increase prices and thus create an implicit (crisis) cartel.

***

In order to preserve growth, or what Gordon (2012) has labelled as a unique episode in human history, the State needs to unleash the installed potential generated over the last 30 years by the information and communication technologies (ICT). In other words, “enabling a structural shift in the economy” is imperative for continued harmonious growth (Perez, 2010, p.4). However, this ‘enabling’ is subject to:

the capacity of the State to restrain the financial casino that typifies the bubble [the recent financial crisis] and to hand over power to production capital, allowing its longer term horizons to guide investment once more (Perez, 2009, p.790).

So far, as the 2008 financial crisis and the post-crisis developments have demonstrated, the State has been incapable of restraining the financial casino. Political reasons and fear of loss of national sovereignty are impeding such process. Thus major financial institutions have rationally decided to pursue a path of collusion, showing their version of self-correcting market – their own ‘visible hand’. The key evidence for such claim is the recent LIBOR scandal.

This cooperative trend, under the current system, could continue up to the point of finding a new and creative way of capital accumulation. The other, more plausible way, is for the State to impose rules that will target the existing insecurity and by implication set off the deployment/golden period. If this is done correctly, it will bring a more secure economic and social environment, based on sustainable development and a new ‘green’ golden age.

Rudi Vrabel holds a postgraduate degree from the University of Manchester and is currently on work placement with the ICCS with an interest in forging links between political economy and the field of security. Following his professional experience at the Slovak department of Defence Policy, International Relations and Legislation, he was interested in the increasing link between security and economic development in Afghanistan, and particularly the relationship between NATO and the World Bank

Image source: Flickr / Jo@net

Bibliography:

Bloomberg, (2013), Hungary Fines 11 Banks $43 Million After Cartel Probe, By Andras Gergely & Marton Eder, November 20, 2013, http://www.bloomberg.com/news/2013-11-20/hungary-fines-11-banks-43-million-after-cartel-probe.html

BIS, (2007), Triennial and Semiannual Surveys on Positions in Global Over-the-counter (OTC) Derivatives Markets at End-June 2007, Bank for International Settlements, Press release, 21 November 2007 at www.bis.org/press/p071121.htm

Denning S., (2013), Big Banks and Derivatives: Why Another Financial Crisis Is Inevitable, Contribution in Forbes Online, http://www.forbes.com/sites/stevedenning/2013/01/08/five-years-after-the-financial-meltdown-the-water-is-still-full-of-big-sharks/

Dore R., (2008), Financialization of the global economy, Industrial and Corporate Change, Vol.17, No.6, pp.1097-112, October 2008

Economist, The, (2013), Too much of a good thing, Octover 12th 2013, Special Report: world economy, Fianncial fragmentation http://www.economist.com/news/special-report/21587378-2008-global-financial-integration-has-gone-reverse-too-much-good-thing?zid=294&ah=71830d634a0d9558fe97d778d723011d

Financial Post, (2013), New banking regulation a threat to global economy: Scotiabank CEO, John Greenwood, 5.9.2013, http://business.financialpost.com/2013/09/05/new-banking-regulation-a-threat-to-global-economy-scotiabank-ceo/

FSA, (2012), FSA Final Notice 2012: UBS AG 19th Dec, The Financial Services Authority, http://www.fca.org.uk/your-fca/documents/final-notices/2013/fsa-final-notice-2012-ubs-ag-19th-dec

Gordon R.J., (2012), Is U.S. Economic Growth Over? Flattering Innovation Confronts the Six Headwinds, Working Paper 18315, NBER Working Papers, August 2012

Hasan I. & Marinc M., (2013), Should Competition Policy in Banking Be Amended during Crises? Lessons from the EU, Forthcoming in the European Journal of Law and Economics, April 17, 2013

Hasman A., (2013), A Critical Review of Contagion Risk in Banking, Journal of Economic Surveys, Vol.27, No.5, pp.978-995,

Kentikelenis A., Karanikolos M., Papanicolas I, Basu S., McKee M., Stuckler D., (2011), Health effects of financial crisis: omens of a Greek tragedy, The Lancet, Vol.378, Iss.9801, pp.1457 – 1458, 22 October 2011

Marinc M. & Razvan V., (2011), The Economics of Bank Bankruptcy Law, Springer

Paraschiv F. & Qin M., (2013), Extreme Spillover Between Shadow Banking and Regular Banking, Working Papers on Finance No.2013/12, Institute of Operations Research and Computational Finance (ior/cf – HSG), July 2013

Perez C., (2009), The double bubble at the turn of the century: technological roots and structural implications, Cambridge Journal of Economics, Vol.33, Iss.4, pp.779-805,

Perez C., (2010), The Advance of Technology and Major Bubble Collapses: Historical Regularities and Lessons for Today, Engelsberg Seminar on “The future of capitalism”, Ax:son Foundation, Sweden, June 2010

Pozsar Z., Adrian T., Ashcraft A. and Noesky H., (2010), Federal Reserve Bank of New York Staff Reports: Shadow Banking, Staff Report no. 458, July 2010, http://www.newyorkfed.org/research/staff_reports/sr458_July_2010_version.pdf

Spendzharova A., (2012), Power to the European Supervisory Authorities: Explaining the Incremental Evolution of European Financial Regulation, Paper prepared for the 2012 UACES conference, Passau Germany, 3-5 September 2012, http://uaces.org/documents/papers/1201/spendzharova.pdf

Telegraph, The, (2012), Bob Diamond: Barclays falsified Libor to protect bank during financial crisis, Harry Wilson, Banking correspondent, 28 Jun 2012, http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/9363421/Bob-Diamond-Barclays-falsified-Libor-to-protect-bank-during-financial-crisis.html

Vives X., (2010), Competition and Stability in Banking, CESifo Working Paper Series 3050, CESifo Group Munich

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s