**3.5 Overconfidence and domestic systemic risk**

As Keynes pointed out, economists—let alone practical people in business—tend to assume that the existing state of affairs will continue indefinitely, unless there are specific reasons to expect a change [52].<sup>26</sup>

international securitization. Equally however, the ability to securitize across international borders creates incentives to not only 'arbitrage' on domestic regulation,

Prior to the GFC, most securitization schemes exploited regulatory regime inconsistences existed among jurisdictions via cross border securitization in order to bypass the existing regulations. In order to make assets isolated from its originator, then practice was to transfer all assets to a SPV. As a result assets will be bankruptcy remote from its originator, which is essential for securitization to work. A SPV is a different entity from its originator. If both the originator and the SPV are in the same jurisdiction, they will be treated as two distinct companies and will be taxed separately. The innovative solution cross boarder securitizer came up with is to set up SPV in tax heavens like Cayman island to avoid U.S tax regulations. As a result, SPV and the originator could avoid US tax regulation, by being two different business entities while on the other hand can reap the benefits of being a separate entity (that is isolating assets from its originator). When a SPV is setup in another jurisdiction it could bypass the U.S Internal Revenue code of 1986, since the SPV is

Banks were able to transfer their risky assets off balance sheet by transferring them to a SVP. As a result banks were able to by-pass the need for reserves. Banks were able to grant more loans and sell them in the same way. In this manner risk

The off-balance-sheet or on-balance-sheet position of an asset depends on the fact wheatear the asset 'transfer' constitutes a sale or is a loan. This is an issue to be dealt with Accounting. Financial Accounting Standard No. 140 identifies elements of a true sale.<sup>29</sup> If a SPV to come under FAS 140, it will be considered a qualified

The U.S Commodity Futures Modernization Act 2000 prohibited Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) regulating Over-the-counter derivatives. The justification is that CDS and similar (over the counter) instruments are transacted by sophisticated parties who can fend themselves and thus there is no need to safeguard such transactions by the SEC and CFTC. Similarly, CDS were (deliberately) not considered insurance contracts. Thus avoided state insurance regulations. State of New York amended the insurance law to exclude CDOs from coverage. The justification is that CDS are

<sup>29</sup> 1. The transferred assets have been isolated from the transferor—put presumptively beyond the reach

2. Each transferee (or, if the transferee is qualifying special-purpose entity (SPE), each holder of its beneficial interests) has the right to pledge or exchange the assets (or beneficial interests) it received, and no condition both constrains the transferee (or holder) from taking advantage of its

3. The transferor does not maintain effective control over the transferred assets through either (1) an agreement that both entitles and obligates the transferor to repurchase or redeem them before their maturity or (2) the ability to unilaterally cause the holder to return specific assets, other than

right to pledge or exchange and provides more than a trivial benefit to the transferor.

See Summary of Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities-a replacement of FASB Statement No. 125 (Issued 9/00), Financial Accounting Standards Board. Online <http://www.fasb.org/summary/stsum140.shtml&pf=true>

SPV and thus need not to include in sponsor's consolidated statements.

but to 'arbitrage' on an international network of legal rules.

*Political and Institutional Dynamics of the Global Financial Crisis*

*DOI: http://dx.doi.org/10.5772/intechopen.90728*

not an entity engaged in U.S trade or business [58].

could be shifted off-balance sheet and off shoe.

**3.7 Was pre-GFC securitization law suboptimal?**

dealing with institutional investors but not consumers [4, 27].

through a clean-up call.

**71**

of the transferor and its creditors, even in bankruptcy or other receivership.

In the years immediately preceding the sub-prime crisis, there was a widespread belief and overconfidence among households, companies and financial institutions themselves that, for the foreseeable future, interest rates would remain relatively low, liquidity relatively high, and house and other key asset prices would continue to rise [53]. Banks and financial institutions continued to lend, underestimating the timing and extent of any future market collapse. A herd mentality<sup>27</sup> developed, resulting in an irrational exuberance<sup>28</sup> in the markets and a speculative bubble, with the attendant risks of losses in the event of its collapse.

Systemic risk can be defined as:

*"the risk that an economic shock, such as market or institutional failure, triggers (through a panic or otherwise) either … the failure of a chain of markets or institutions or … a chain of significant losses to financial institutions, … resulting in increases in the cost of capital or decreases in its availability, often evidenced by substantial financial market price volatility" [54]*.

Before the sub-prime crisis and the GFC, the United States was the world's largest economy on a GDP basis, and remains so. The U.S. Dollar is the world reserve currency. It is hardly surprising that global investor confidence is largely dependent on the state of U.S. financial markets and the health of the U.S. economy.

When U.S. house prices collapsed in the wake of the sub-prime crisis, and financial institutions globally perceived the riskiness of other financial institutions and companies (so-called counterparty risk) increasing, they lost confidence in each other's credit servicing ability, ceasing not only to continue to purchase residential mortgage-backed securities in the U.S., but also commercial asset-backed and nonasset-backed securities in the U.S. and elsewhere.

The network interconnectedness of bank finance globally can, in the event of a sufficient economic shock, transmit to a broader systemic shock if a sufficient number of banks (or sufficiently important banks) make sufficient losses that they themselves become unable to service their debts, not only to their depositors but to other banks. In the wake of the sub-prime crisis, the loss of confidence in the wholesale markets had the effect of reducing the supply of inter-bank credit, which in turn reduced the availability of credit in retail markets, and contributed to the collapse of the real economy in the United States [55, 56].

#### **3.6 Cross-border securitization as regulatory 'arbitrage'**

Investment opportunities may plainly expanded by not limiting securitization arrangements to one domestic jurisdiction, but by engaging in cross-border or

<sup>26</sup> Keynes further argued that, by its very nature, entrepreneurship must always remain partly skill and partly chance: if human nature had no inclination to take risks, there might not be much long-term investment.

<sup>27</sup> A herd mentality arises when every market participant, knowing that everybody (including themselves) has incomplete information about the value of a particular behaviour, rationally (*ex-ante*) interprets others' consistent prior choices as evidence of the value of that behaviour, and replicates it [57].

<sup>28</sup> Shiller R.J. (2005), *Irrational Exuberance*, Crown, New York.

### *Political and Institutional Dynamics of the Global Financial Crisis DOI: http://dx.doi.org/10.5772/intechopen.90728*

**3.5 Overconfidence and domestic systemic risk**

the attendant risks of losses in the event of its collapse.

*substantial financial market price volatility" [54]*.

asset-backed securities in the U.S. and elsewhere.

collapse of the real economy in the United States [55, 56].

**3.6 Cross-border securitization as regulatory 'arbitrage'**

<sup>28</sup> Shiller R.J. (2005), *Irrational Exuberance*, Crown, New York.

investment.

it [57].

**70**

specific reasons to expect a change [52].<sup>26</sup>

*Financial Crises - A Selection of Readings*

Systemic risk can be defined as:

As Keynes pointed out, economists—let alone practical people in business—tend to assume that the existing state of affairs will continue indefinitely, unless there are

In the years immediately preceding the sub-prime crisis, there was a widespread belief and overconfidence among households, companies and financial institutions themselves that, for the foreseeable future, interest rates would remain relatively low, liquidity relatively high, and house and other key asset prices would continue to rise [53]. Banks and financial institutions continued to lend, underestimating the timing and extent of any future market collapse. A herd mentality<sup>27</sup> developed, resulting in an irrational exuberance<sup>28</sup> in the markets and a speculative bubble, with

*"the risk that an economic shock, such as market or institutional failure, triggers (through a panic or otherwise) either … the failure of a chain of markets or institutions or … a chain of significant losses to financial institutions, … resulting in increases in the cost of capital or decreases in its availability, often evidenced by*

largest economy on a GDP basis, and remains so. The U.S. Dollar is the world reserve currency. It is hardly surprising that global investor confidence is largely dependent on the state of U.S. financial markets and the health of the U.S. economy. When U.S. house prices collapsed in the wake of the sub-prime crisis, and financial institutions globally perceived the riskiness of other financial institutions and companies (so-called counterparty risk) increasing, they lost confidence in each other's credit servicing ability, ceasing not only to continue to purchase residential mortgage-backed securities in the U.S., but also commercial asset-backed and non-

Before the sub-prime crisis and the GFC, the United States was the world's

The network interconnectedness of bank finance globally can, in the event of a

Investment opportunities may plainly expanded by not limiting securitization arrangements to one domestic jurisdiction, but by engaging in cross-border or

<sup>26</sup> Keynes further argued that, by its very nature, entrepreneurship must always remain partly skill and partly chance: if human nature had no inclination to take risks, there might not be much long-term

<sup>27</sup> A herd mentality arises when every market participant, knowing that everybody (including themselves) has incomplete information about the value of a particular behaviour, rationally (*ex-ante*) interprets others' consistent prior choices as evidence of the value of that behaviour, and replicates

sufficient economic shock, transmit to a broader systemic shock if a sufficient number of banks (or sufficiently important banks) make sufficient losses that they themselves become unable to service their debts, not only to their depositors but to other banks. In the wake of the sub-prime crisis, the loss of confidence in the wholesale markets had the effect of reducing the supply of inter-bank credit, which in turn reduced the availability of credit in retail markets, and contributed to the

international securitization. Equally however, the ability to securitize across international borders creates incentives to not only 'arbitrage' on domestic regulation, but to 'arbitrage' on an international network of legal rules.

Prior to the GFC, most securitization schemes exploited regulatory regime inconsistences existed among jurisdictions via cross border securitization in order to bypass the existing regulations. In order to make assets isolated from its originator, then practice was to transfer all assets to a SPV. As a result assets will be bankruptcy remote from its originator, which is essential for securitization to work. A SPV is a different entity from its originator. If both the originator and the SPV are in the same jurisdiction, they will be treated as two distinct companies and will be taxed separately. The innovative solution cross boarder securitizer came up with is to set up SPV in tax heavens like Cayman island to avoid U.S tax regulations. As a result, SPV and the originator could avoid US tax regulation, by being two different business entities while on the other hand can reap the benefits of being a separate entity (that is isolating assets from its originator). When a SPV is setup in another jurisdiction it could bypass the U.S Internal Revenue code of 1986, since the SPV is not an entity engaged in U.S trade or business [58].

Banks were able to transfer their risky assets off balance sheet by transferring them to a SVP. As a result banks were able to by-pass the need for reserves. Banks were able to grant more loans and sell them in the same way. In this manner risk could be shifted off-balance sheet and off shoe.

The off-balance-sheet or on-balance-sheet position of an asset depends on the fact wheatear the asset 'transfer' constitutes a sale or is a loan. This is an issue to be dealt with Accounting. Financial Accounting Standard No. 140 identifies elements of a true sale.<sup>29</sup> If a SPV to come under FAS 140, it will be considered a qualified SPV and thus need not to include in sponsor's consolidated statements.

#### **3.7 Was pre-GFC securitization law suboptimal?**

The U.S Commodity Futures Modernization Act 2000 prohibited Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) regulating Over-the-counter derivatives. The justification is that CDS and similar (over the counter) instruments are transacted by sophisticated parties who can fend themselves and thus there is no need to safeguard such transactions by the SEC and CFTC. Similarly, CDS were (deliberately) not considered insurance contracts. Thus avoided state insurance regulations. State of New York amended the insurance law to exclude CDOs from coverage. The justification is that CDS are dealing with institutional investors but not consumers [4, 27].

<sup>29</sup> 1. The transferred assets have been isolated from the transferor—put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership.

<sup>2.</sup> Each transferee (or, if the transferee is qualifying special-purpose entity (SPE), each holder of its beneficial interests) has the right to pledge or exchange the assets (or beneficial interests) it received, and no condition both constrains the transferee (or holder) from taking advantage of its right to pledge or exchange and provides more than a trivial benefit to the transferor.

<sup>3.</sup> The transferor does not maintain effective control over the transferred assets through either (1) an agreement that both entitles and obligates the transferor to repurchase or redeem them before their maturity or (2) the ability to unilaterally cause the holder to return specific assets, other than through a clean-up call.

See Summary of Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities-a replacement of FASB Statement No. 125 (Issued 9/00), Financial Accounting Standards Board. Online <http://www.fasb.org/summary/stsum140.shtml&pf=true>

On one hand CDSs were not regulated as insurance enabling non-insurable interest holders gaining protection over default of an entity, ultimately leading to betting. On the other hand no authority was overseeing the process. As a result when sup-prime borrowers defaulted, the loss was passed to the investor and then to the CDS provider. Near bankruptcy of AIG is the classic example of risk transfer from the lender to the insurer via the investor. Finally when AIG was bailout, the loss was actually shifted to the U.S treasury in lieu of tax payer [27].

## **4. Summary**

This chapter has sought to provide a contextual background to those that follow. The effects of excess system liquidity and easy credit conditions, executive compensation arrangements which encouraged excessive risk-taking (e.g. through financial innovations such as loan securitization), banking and investment activity that sought to circumvent extant regulation, and the bursting of the U.S. housing bubble together culminated in the U.S. sub-prime crisis. Further, because many U.S. institutions and corporates had entered into contracts (e.g. securitization contracts, insurance/sub-insurance contracts, and credit default swaps) which spanned jurisdictions, the effects of what would otherwise have been a primarily U.S. sub-prime crisis were felt beyond the United States, in Britain and elsewhere in Europe.

This chapter identified and described the salient or root causes of the GFC. Law and legal regulation create incentives and disincentives for market participants to behave in particular ways. A desire for innovation, fuelled by high levels of system liquidity and executive compensation arrangements that encouraged management to undertake high levels of risk, together with a speculative bubble in the U.S. housing market and incomplete regulation, gave rise to highly complex financial products. In the presence of asymmetric information, this complexity gave rise to uncertainty and incomplete contracting, which featured significant moral hazard and adverse selection. Overconfidence in a rising market and lapses of ethical judgement when faced with incomplete regulation resulted, with the collapse of the U.S. housing bubble, in a loss of confidence in U.S. markets, contributing to systemic risk and so-called cross-jurisdictional 'contagion'. Whether this so-called 'contagion' is true contagion or mere contractual interdependence between institutions in different jurisdictions, is a separate matter.

As far as policy implications are concerned, regulating asset backed securities and associated derivatives would be a *prima facie* solution for the mortgage crisis. Yet, there should be wide financial policies to prevent a similar crisis, since; next time it would be some other asset that may create the asset bubble. Financial intelligence units of each individual nation should extend their scope in order to monitor developments in financial bubbles. Like in China, any innovative financial instrument should be registered with financial intelligence units and their mechanism should be analyses and measured in terms of financial safely of the innovation.

**Author details**

Shanuka Senarath

**73**

provided the original work is properly cited.

Department of Economics, University of Colombo, Colombo, Sri Lanka

*Political and Institutional Dynamics of the Global Financial Crisis*

*DOI: http://dx.doi.org/10.5772/intechopen.90728*

\*Address all correspondence to: shanuka.senarath@griffithuni.edu.au

© 2019 The Author(s). Licensee IntechOpen. This chapter is distributed under the terms of the Creative Commons Attribution License (http://creativecommons.org/licenses/ by/3.0), which permits unrestricted use, distribution, and reproduction in any medium,

There will be no permanent solution to prevent a future for a financial crisis. All we can (and should) do is to avoid financial bubbles that may lead to a crisis. We never know when it would be the next crisis. Yet, we ought to know at least a few things. We know for a fact that it would be some financial asset that will create an asset bubble. There will be associated factors that may contribute to the creation of the bubble. For example financial innovation, law create incentives, etc. All we got to do is keeping an open eye on associated factors and their movements. Global regulation such as BASEL accords can influence individual financial systems to take necessary regulatory measures to regulate and control associated factors of a financial crisis.

*Political and Institutional Dynamics of the Global Financial Crisis DOI: http://dx.doi.org/10.5772/intechopen.90728*

On one hand CDSs were not regulated as insurance enabling non-insurable interest holders gaining protection over default of an entity, ultimately leading to betting. On the other hand no authority was overseeing the process. As a result when sup-prime borrowers defaulted, the loss was passed to the investor and then to the CDS provider. Near bankruptcy of AIG is the classic example of risk transfer from the lender to the insurer via the investor. Finally when AIG was bailout, the

This chapter has sought to provide a contextual background to those that follow. The effects of excess system liquidity and easy credit conditions, executive compensation arrangements which encouraged excessive risk-taking (e.g. through financial innovations such as loan securitization), banking and investment activity that sought to circumvent extant regulation, and the bursting of the U.S. housing bubble together culminated in the U.S. sub-prime crisis. Further, because many U.S. institutions and corporates had entered into contracts (e.g. securitization contracts, insurance/sub-insurance contracts, and credit default swaps) which spanned jurisdictions, the effects of what would otherwise have been a primarily U.S. sub-prime crisis were felt beyond the United States, in Britain and elsewhere in Europe.

This chapter identified and described the salient or root causes of the GFC. Law and legal regulation create incentives and disincentives for market participants to behave in particular ways. A desire for innovation, fuelled by high levels of system liquidity and executive compensation arrangements that encouraged management to undertake high levels of risk, together with a speculative bubble in the U.S. housing market and incomplete regulation, gave rise to highly complex financial products. In the presence of asymmetric information, this complexity gave rise to uncertainty and incomplete contracting, which featured significant moral hazard and adverse selection. Overconfidence in a rising market and lapses of ethical judgement when faced with incomplete regulation resulted, with the collapse of the U.S. housing bubble, in a loss of confidence in U.S. markets, contributing to systemic risk and so-called cross-jurisdictional 'contagion'. Whether this so-called 'contagion' is true contagion or mere contractual interdependence between institu-

As far as policy implications are concerned, regulating asset backed securities and associated derivatives would be a *prima facie* solution for the mortgage crisis. Yet, there should be wide financial policies to prevent a similar crisis, since; next time it would be some other asset that may create the asset bubble. Financial intelligence units of each individual nation should extend their scope in order to monitor developments in financial bubbles. Like in China, any innovative financial instrument should be registered with financial intelligence units and their mechanism should be analyses and measured in terms of financial safely of the innovation. There will be no permanent solution to prevent a future for a financial crisis. All we can (and should) do is to avoid financial bubbles that may lead to a crisis. We never know when it would be the next crisis. Yet, we ought to know at least a few things. We know for a fact that it would be some financial asset that will create an asset bubble. There will be associated factors that may contribute to the creation of the bubble. For example financial innovation, law create incentives, etc. All we got to do is keeping an open eye on associated factors and their movements. Global regulation such as BASEL accords can influence individual financial systems to take necessary regulatory measures to regulate and control associated factors of a finan-

loss was actually shifted to the U.S treasury in lieu of tax payer [27].

tions in different jurisdictions, is a separate matter.

**4. Summary**

*Financial Crises - A Selection of Readings*

cial crisis.

**72**
