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The Role and Character of Law in Financial Markets

Submitted Assignment 2015 7 Pages

Economics - Finance

Excerpt

Introduction

Before the 2008-2009 global financial crisis, law was a necessary tool for financial markets. English financial law represents “the entire body of legal rules that govern and regulate financial markets, financial assets and financial transactions under the law of England and Wales”. It is classified as “a sub-species of English commercial law, which is heavily influenced by English common law” (Ce Fi MS, unit 2, p.12)[1].

According to Ellinger et al. (2011, pp.27-28), « in order to safeguard the stability of the banking system, a degree of regulation and supervision needs to be imposed on banks themselves ». In this context, the United Kingdom (UK) passed the Financial Services and Markets Act 2000 (FSMA 2000), which authorized the Financial Services Authorities (FSA) to become « a super-regulator , having responsibility for the regulation and supervision of the whole financial services sector ». However, this regulatory system was not suited for adressing the difficulties the banks were going into during the global financial crisis of 2008-2009. After the crisis, law and regulation's role shifted to provide more protection for financial stability and for the prevention of any misconducts. The Banking Act 2009 was going to fill the gap in « dealing with pre-insolvency 'stabilization' and with banking insolvency and administration ». And a year later, the Financial Services Act 2010 was given the role of « strengthening the powers of the FSA and giving it a 'financial stability' objective.[2]

In this paper, we are going to critically discuss the different views on the role of law and finance before and after the financial crises areas.

Development

Law and Finance

Both legal and political institutions play important roles in providing trust and stability for the market's workability. Focus here will be given on the importance of law, as the stability and success of financial systems and markets lie within “a sound legal and regulatory framework” (Ce Fi MS unit 1, pp.10, 3). It is widely acknowledged that “financial systems cannot operate in a legal vacuum”. The legal system is the one that “defines property rights, allows for exchange of property rights, and protects property rights”. The importance of the rule of law is thus exemplified by “countries with a rule of law and established property rights [which] are more prosperous and grow more quickly”(Ce Fi MS unit 1, p.18). [3] In this context, the United Kingdom and its English law has become “the predominant choice of financiers and their lawyers as the law governing financial contracts”. (Ce Fi MS unit 2, p.3) The reason is mainly because English law “provide certainty (…) in the rights and obligations of the parties, and predictability of the outcome in the event of legal disputes”. (Ce Fi MS unit 2, pp.8-9) . Indeed, the presence of “law and regulation ensure that financial transactions are carried out within a clear, predictable and enforceable legal framework” (Ce Fi MS unit 1, p.9). While, a dire consequence would be that “the entire financial system would collapse under the uncertainty caused in the absence of legal institutions” (Ce Fi MS unit 1, p.10). In other words, “the legal and regulatory framework is significant for the strength and soundness of the financial system and the certainty of individual contracts and transactions”(Ce Fi MS unit 1, p.13).[4]

Law and Economics

In the realm of economics, different views agrees on the link between economics and law, where law's foundation stems from economics. According to Goodhart C (1997), reffering to Posner and other scholars (Economic Analysis of Law, Boston :Little Brown, 4th ed, 1992), « the structure of the law can be shown to have economic roots ». Posner (pp.264-265) defines the law as « wealth maximization [which] provides a foundation not only for a theory of rights and of remedies, but for the concept of law itself. » He (pp.23, 523) also argues that common law is « a system for maximizing the wealth of society ». Goodhart C (1997, pp.3-4) states that, « the economist sees the law as a means of applying and maintaining appropriate incentive structures in society » , and that « private, competitive markets depend on a comprehensive legal structure ». Quoting Coase R. (The Firm, the Market and the Law, pp.9-10), « examples of a perfect market and perfect competition, are markets in which transactions are highly regulated (...), in order to reduce transaction costs and therefore to increase the volume of trade ». Along with Posner, Coase (pp.27-28) also acknowledged the importance of law in economic policy, which « consists of choosing those legal rules, procedures and administrative structures which will maximize the value of production » [5]

An economic issue illustrating the importance of law is, the average income gap between the richest and poorest nations in the world. Rodrik and Subramanian (2003, pp.31-32, 34) view institutions, especially property rights and the rule of law, as determining income levels. They argue that in the absence of institutions that protect property rights and enforce contracts, market would « either de not exist or perform very poorly ». It is in this view, that the organizations such the IMF and the World Bank determine their conditions for loans according to country's fulfillment of the « basic requirements for a basic institutional framework : rule of law, independent judiciary, free press, and participatory politics. »[6]

Regulating the international economic system

The victorious states of World War II met in 1944 in Bretton Woods, New Hampshire, to discuss the regulatory frawework for the international economic system, which was to be called the Bretton Woods System. The World Bank, International Trade Organization, and the International Monetary Fund were formed, and helped bring stability over the next decades through « the fixed exchange rate system required strict capital controls, which meant that financial markets at the time were largely un-integrated , (...) which allowed most advanced economies experienced steady growth while inflation and interest rates remained low and steady. Describing this financial era, Turk argues that it was « a relatively halcyon time when finance was not yet global in character, and as a result, required little international regulatory attention beyond the IMF’s role in coordinating exchange rates » (Turk 2014, pp.66-67).[7] However, the system was not to last because of the unilateral decision of the US in the 1970s to end the US dollar convertibility to gold, and thereby making this US dollar, the reserve currency.

Meanwhile, financial crises took place in the emerging economies of Mexico and East Asia. While law plays an essential role in economic policy, there is a need for a strong legal system in place before implementing rigorous economic policy. Analyzing the Asian financial crises , Walker (2000, pp.58-60) notes that the weak legal and regulatory frameworks, i.e. “the inappropriate sequencing of financial deregulation and liberalization, and the lack of prudential supervision of the financial system, were the important factors contributing to the Asian financial crisis.” He emphasized the importance of sequencing, i.e. that “capital markets need supervisory and regulatory structures in place before broad-based financial deregulation and liberalization are introduced.” In other words, “a developing and maturing legal system can reduce the likelihood of a financial crisis”, because a well-developed legal and regulatory framework would bring confidence and stability for a market economy to thrive.[8]

In response to the 1990s financial crisis, the New International Financial Architecture (NIFA) comprised of « informal state-to-state bodies, transgovernmental networks, and private industry organizations [which] arose, all with varying aims and degrees of legalization », and sharing the thought that « developed economies had essentially sound financial systems, developing countries had dysfunctional and improperly regulated banking sectors that needed to be reformed to resemble their more advanced counterparts ». In this context, the Group of 7 (later the G8) was formed to provide « an informal state-to-state forum where heads of government of the seven largest economies met annually » with the aim of taking « steps to facilitate the process of developing global standards for financial regulation after the 1990s crises ». Within the frame of the NIFA, the Basel Committee improved its Basel Accords on capital adequacy and adopted the Basel II agreement in 2004. (Turk 2014, pp.69-71)[9]

However, the 2006 fall in house prices in the US and Europe, led to « a severe drop in housing prices, [and], defaults on mortgages », and more importantly « a generalized chaos in credit markets », that led some European countries to become indebted and receive emergenciy aid. Ultimately, the 2008 financial crisis took place with the British bank Northern Rock (in 2007), and the US banks Bear Stearns and Lehman Brothers (in 2008) failures. Turk argues that , « as with Basel I, a compelling case can be made that Basel II had no positive effect on the capitalization of the banking sector or the stability of the global financial system » (Turk 2014, p.72-73).[10]

While the global financial crisis seems to be mainly related to the weakness of the then regulatory framework, in the end States still have to solve their interdependence issues. Turk (2014, p.61) assumes that « rational states are the ultimate actors in international law », as States craft international rules and institutions to capture the joint gains available from correcting international externalities, which are :

(1) harmonizing financial standards to lower the cost of cross-border transactions and increase the efficiency of financial integration; (2) maintaining the capital adequacy of financial institutions across jurisdictions to prevent crises ex ante; and, managing crises ex post by (3) establishing a cross-border resolution mechanism to unwind failed firms, and by (4) implementing an international lender-of-last-resort function to intervene in sovereign debt or currency crises» Turk (2014, p.62).[11]

[...]


[1] Center for Financial and Management Studies (CEFIMS), 2013. Financial Law, Units 1 to 4. London.

[2] Ellinger, E, Lomnicka E & Hare C (2011), 'Ellinger's Modern Banking Law', Oxford University Press.

[3] Center for Financial and Management Studies (CEFIMS), Financial Law, Units 1 to 4. London.

[4] Ibid.

[5] Goodhart, C A E (1997), 'Economics and the Law: Too Much One-Way Traffic?', Modern Law Review, Vol. 60, No. 1, pp1-22.

[6] Rodrik, D & A Subramanian (2003), 'The Primacy of Institutions', Finance and Development, Vol. 40, No. 2, June

[7] Turk, M C (2014), 'Reframing International Financial Regulation After the Global Financial Crisis: Rational States and Interdependence, not Regulatory Networks and Soft Law', Michigan Journal of International Law, Vol. 36, Issue 1. http://repository.law.umich.edu/mjil/vol36/iss1/2

[8] Walker, J L (2000), 'Building the Legal and Regulatory Framework', Building an Infrastructure for Financial Stability, Conference Series No. 44, (E S Rosengren & J S Jordan eds.), paper presented at the Conference of the Federal Reserve Bank of Boston, June

[9] Turk, M C (2014), 'Reframing International Financial Regulation After the Global Financial Crisis: Rational States and Interdependence, not Regulatory Networks and Soft Law', Michigan Journal of International Law, Vol. 36, Issue 1. http://repository.law.umich.edu/mjil/vol36/iss1/2

[10] Ibid.

[11] Ibid.

Details

Pages
7
Year
2015
ISBN (eBook)
9783668746954
File size
457 KB
Language
English
Catalog Number
v432707
Institution / College
School of Oriental and African Studies, University of London – CEFIMS
Grade
65.00
Tags
Role Character Law Finacial Markets Rules Money Crisis

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Title: The Role and Character of Law in Financial Markets