Introduction
Following the recent global economic downturn, it is clear that the response of central banks and governments is likely to shape the future of our financial markets for many years to come. Their responses in regulating fields such as credit rating agencies, derivative markets and hedge funds will be crucial in relation to economic recovery. Over the course of our essay, we will also discuss areas such as international trade, geo-political issues and the role of monetary authorities in the future as the global economy aims to bounce back from the worst downturn since 1929. We will begin our assessment by first taking a look at the future regulation of financial markets.

Regulation of Financial Markets
Credit Rating Agencies
Credit Rating Agencies (CRA) are responsible for assigning a credit rating to financial instruments such as bonds, companies, governments, etc. By current regulation any financial instrument must receive a credit rating from at least two CRAs. The problem with this is that there are only three companies which control roughly 85% of the market. These companies are Standard & Poors, Moodys and Fitch. The need for regulation in this market is now coming under increasing pressure. These companies first came under scrutiny after the collapse of Enron because the company still had a top AAA rating one week prior to filing for bankruptcy but subsequently the credit rating agencies were overshadowed by the failures of auditors and thus were never regulated more sternly.
Another problem with these CRAs is that they offer “advisory services” which creates huge mark ups for the firms. Basically, companies pay to find out how they should structure securitised assets such as mortgage back securities and then the same company gives them a top rating for using their service. This is a huge conflict of interest and the question must be asked should this market be allowed to continue like this? The market may be allowed to continue as it is and hope new competition challenges the current big three such as a new company backed by entrepreneur Jules Kroll which started trading on 19 January this year as reported by the Financial Times. We think the market will be regulated soon but it remains to be seen how regulators will go about this. Possibly there may be regulation introduced which would aim to dilute the market more, therefore making it more competitive, and possibly companies may have to attain more credit ratings than just two? But then again gaining more credit ratings is surely just passing on further fees to customers and would not be a viable option for us.
We personally think CRAs should be government run. After all there are huge profits to be made in this market and why should this be made by a few firms who maintain super normal profits in this oligopolistic market. Maybe our struggling government could with a few profit making firms but this does raise the question of a moral hazard issue. For me this should not be a major stumbling block in the need for more stringent credit rating policies and the need for a more neutral CRA is certainly needed to reduce this conflict of interest. In our view CRAs should certainly be government run to reduce the risk of another bail out.
The reliance on credit rating agencies is another aspect that needs to be looked at. Investors including hedge funds use these credit ratings as the most important aspect of valuing assets residuals cash flows but this was never meant to be. CRAs are only meant to supplement an investors own take on the riskiness of an asset and not be their only research.
Another major problem which CRAs have is attracting highly educated personnel to value the sophisticated models in which banks use to value their assets such as asset backed securities. These highly educated persons can attain far higher salaries in financial institutions and therefore this is another reason why we feel governments should be involved in running the CRAs as they maybe better at attracting this kind of personnel.

Hedge Funds
Hedge funds function by making very frequent trades in stocks, bonds and financial derivatives and in recently there has been call for further regulation within the sector. Presently, hedge funds do not need to disclose or report activities like other companies and some want this to change. We feel this is ludicrous as studies show that hedge funds were not at all to blame for the current crisis and therefore should not have to pay for other financial institutions shortcomings.
People are worried about how leveraged some hedge funds are but a recent study by the Organization for Economic Co-operation and Development shows the average hedge fund is only leveraged 3.9 to 1, debt to equity ratio (1) while by contrast, banking sector leverage generally ranges from about 12-17 to 1 while major U.S. investment bank leverage in particular ranged from 20-33 to 1(2). Others claim hedge funds are too systematically important and are worried about herding affects. These claims feel that regulation to force hedge funds report their activity may help prevent this herding effect but we feel that this will accentuate the herding affect as all firms will know each other’s activity. We feel that claims that hedge funds are too ‘systematic important’ is also ridiculous as in September 2006, the $6.6 billion hedge fund Amaranth Advisors set an industry record for the largest hedge fund collapse, yet its creditors and the broader financial system experienced no significant disruptions (3). With these above points in mind, we feel it is crucial that we do not over regulate hedge funds as they are crucial to our financial recovery.

Investment/Commercial Banks
Commercial banks provide checking accounts, savings accounts, and provide loans to its customers. On the other hand, investment banks engage in intermediary services such as advice on raising capital and mergers and acquisitions, and are also involved in trading. The reason for this separation was that commercial banks held little risk of default and therefore could become systematically important to the economy and investment banks bared higher levels of risk and therefore were expected to fail from time to time. So where did these two separate businesses become one?
After the Wall Street crash of 1929, the Glass-Steagall Act was enacted in 1933, which meant that commercial banks were not allowed to engage in investment banking activities and vice-a-versa. This, however, was revoked in 1999 by the Gramm-Leach-Biley Act. Although the act was not policed very stringently prior to 1999, this new act gave license for commercial/investment banks to become one entity and thus, both would now become systematically important. It is almost impossible now for regulators to draw the line between these two apparent separate businesses. Even our national banks such as AIB and Bank of Ireland have mass trading departments which have helped to nearly cripple our economy. Ex-FED chairman Paul Volcker, speaking on 6 March 2009, told about the need to separate these activities once more. Commercial banks would provide customers with depository services and access to credit and would be highly regulated, while securities firms would have the freedom to take on more risk and practice trading “relatively free of regulation” (Bloomberg).
We do feel that we need to separate these banking activities but not all the way back to the separation that existed when the Glass-Seagall act was enacted. I believe that commercial banks should still be allowed to provide intermediary services to customers but definitely not engage in almost hedge fund like trading activities. This separation process would stabilize the systematically important commercial banks and hopefully in the long term, make the investment banks unsystematically important and therefore should be able to fail like any other institution.
This separation along with the increased capital buffers, etc. which is being enacted through Basel III, should allow commercial banks to be stable and not require bailouts even in the harshest of economic periods.

Risk Management
Although nearly all companies engage in some form of risk management, we feel that not nearly enough regulation is in place to implement these “worst case scenario” event plans such as the current economic crisis. New legislation is needed to implement more stringent risk management plans for companies and make these “worst case scenario” plans available to all potential investors to see. One such risk assessment which we feel should be compulsory for all companies to assess is Value at Risk (VaR). VaR is a recent development to help investors operationalize risk. VaR helps to measure, quantify and express risk and is therefore the downside to an investment. It measures at a particular level of confidence, what maximum losses may occur in a day. Ie. If a firm estimated that at 95% level of confidence, they may incur a daily trading loss of $200 million; this would mean that there is a 5% chance that $200million dollars would be lost in a day’s trading. we believe investors deserve to know this information and it should at least be made compulsory for publicly traded stock.
Although the new Basel plans aim to require large banks to calculate 10 day VaR, it does not however make the financial institutions disclose this information to the public. The main problem with VaR at the moment is comparison between different companies as there is no standardized VaR formula. As put in the Financial Times “Measurements of Value at Risk is like Snowflakes – no two alike (Financial Times). Differences between VaR calculations include confidence interval, length of potential losses and the length of historical data used. Until these differences are standardized and results disclosed to the public, we feel VaR will not be very useful to us as investors.

International Trade
Of course the recent economic turmoil will have a massive impact on the state of International trade now and also in the future. The immediate effect of the credit crunch was of course a decrease in demand and with this comes a decrease in trade. A country’s imports will obviously be linked positively to it’s economic size and stability, such that during contraction imports will decrease. At the same time, a reduction in exports can result in a decrease in the demand for domestic goods. Thus placing us in a vicious cycle of contracting international trade and a deteriorating world economy. In looking at how we should deal with such a difficult situation we must first look at the actions of our predecessors following the 1929 Wall St. crash and the resultant great depression. The United States’ immediate reaction was to introduce The Smoot Hawley Tariff Act, this saw massive tariff increases on imports in an attempt to restrict them; the idea was to protect the domestic industries and employment. However this clearly enraged other countries that saw a decline in their US exports, their retaliation was to impose large tariffs on US imports, and this resulted in a deepening of the depression. This time around it is vital that we avoid this style of nationalistic protectionism and avoid the erection of any barriers to international trade. This was addressed by the G20 summit, but it is essential that the WTO (world trade organization) performs correctly, and diligently monitors countries actions and prevents any protectionist policies. The WTO needs to step up its game as a trade watchdog as any change in policy from a leading international trade country could have detrimental knock on effects for the global economy. Moving forward, it appears that China is best positioned to take advantage of any upturn in the market. Although it does appear that there is going to be a crackdown from the US on China’s trade practices and their manipulation of the Yuen’s exchange rate (Obama has been under serious pressure from different sectors in recent times to get tough on the Chinese trade policies etc.) we feel that due to the extremely favorable subsidies available from the Chinese government Chinese companies will be left in a very competitive position. In fact even now, although the quantity of Chinese imports has decreased in America, they are actually taking up a larger portion of the imports in certain industries, such that they are taking up a larger share of a smaller pie. This is down to the increase in price competition. We feel the pressure put on Obama is justified; it is essential that an end be put to the fixed exchange rate of the Yuen. This needs to be done if we are to see an end to the current distortion in international trade, which has seen Asian and OPEC countries current account surpluses sky rocket, with the US’s and UK’s deficits doing likewise.

Derivatives
Securitisation
In the aftermath of the financial crisis, many experts were blaming asset and mortgage backed securities (ABS)/(MBS) as the main reason for the economic downturn. Most mundane people who didn’t even know what an MBS was were blaming the MBS for their economy being ruined, but were they right? In our opinion, the lack of regulation in this market was largely to blame for the crisis but how are we going to fix this? Illiquid asset should not become liquid just because they have “steady” cash flows and offer high returns to investors at “low” risk. Companies who have a credit rating of BB should not be allowed to borrow at AAA rates just because their securitized asset is rated AAA. In fact, since they have securitized their most liquid assets and taken them off their balance sheet shouldn’t their rating decrease? We think this is an area in which stricter regulation is needed. Bank workers selling mortgages to people should not work off commission determined by volume just like they are working in a clothes store. These loans sellers should not be allowed to give hundreds of thousands of euro to customers when this amount is ten times their annual salary and know that any interest rate increase will mean that the customer will default on the loan causing the MBS to default. CRA were unable to keep up with the volume of securitizing before the collapse. In 2007, it was estimated that $4 trillion worth of ABS were issued alone which doubled the market size. There is no way CRAs could have checked each individual mortgage to ensure it was a AAA rating. So how do we regulate this? First of all, we feel it is imperative that financial institutions keep a percentage of their securitized assets on their own balance sheet and not be allowed to transfer all of the risk to a third party. Financial institutions should not be allowed to transfer these ABS to off balance sheet special purpose vehicles in which they receive “legal remoteness”. This means that they are longer liable in the event of bankruptcy. Governments and central banks must really look into how to regulate this market but it is tough. For us the best way to regulate it is to ensure that issuer’s keep a percentage of the ABS on their own balance sheet (around 10%) and that more information about the assets is disclosed to investors so they can make up their own risk assessment of the asset.

When looking at OTC Derivatives in order to look forward to the future we again need to take a look at the problems with the past. OTC derivatives have been largely exempt from regulatory oversight, which led to an uncertainty regarding the exposure of various institutions to OTC derivatives; this hindered any rescue plan that ensued following the financial crisis. Due to this we feel the aim going forward should be increased regulation and transparency in the OTC markets. This could be done by giving the Commodity Futures Trading Comission (CFTC) and Securities and Exchange Commission (SEC) increased power when it comes to imposing recordkeeping and reporting requirements as well as policing things like fraud, market manipulation etc. Also any standardized contracts could be put through Central Counterparties (CCPs) and any not cleared by them put through a regulated trade repository, the info gathered by these CCPs and trade repositories could then be passed onto federal regulators. The use of CCPs would not only help on the regulation side of things, but also as they would be taking on the responsibility for the calling and receiving of margin and collateral they would promote confidence in the market. Thus helping to increase liquidity. All of these measures would make the OTC market more visible and user friendly to investors, hopefully increasing confidence. However there are objections to this increased regulation and control and we feel it could very easily bring with it some negative effects. Such stringent regulation could see company’s turning away from the use of OTC derivatives thus only contributing to a less efficient economy. There is massive economic opportunity cost to going through the exchanges, as more cash collateral will be required when going through CCPs. At the moment collateral is negotiated privately between parties, such that it can be tailored to include less liquid capital. Also a lot of companies are conscientious users of OTC derivatives, using them for legitimate hedging purposes, they argue that it is the speculators that should be bearing these costs. This brings with it even greater problems, how does one draw the line between hedgers and speculators? The answer: with exceptional difficulty to the regulators.

Geo-Political
There are many geo-political issues which need to be discussed before any new regulation is properly introduced. Even within the eurozone, countries cannot decide on the best course of action to propel countries and the euro to economic recovery. The two most powerful countries in the eurozone, France and Germany are in disagreement as to whether our banks should hold more debt or capital.
The ever efficient Germany is demanding fiscal prudence where as France are demanding more leeway in the capital requirement debate which is adding to more uncertainty within the market. In our opinion Germany are correct in demanding more capital to be held within the Banking sector and who are we to disagree with them as they seem to be the only shinning light within the EU at the moment. Not many of the other governments in the EU can honestly say their policies are working so maybe we should just adopt their policies and opt for fiscal prudence? Whatever outcome the EU and/or ECB decide on, we feel it needs to be quick and united. The last thing the market needs is uncertainty with the Euro on the verge of extinction. As put in the financial times on 8 December last: Unless the EU takes radical steps to transform the government of the eurozone, the single currency experiment is likely to fail (FT). Therefore, we believe that the super powers of the euro can fight all they want about what resolution they would prefer but if there is not a unified response soon from the EU, it could happen that Geo-political issues between the member states are the eventual final factor in the destruction of our single currency.
Another key issue which will need to be discussed and agreed upon if we are to minimize the chance of a repeat global economic downturn of this size again is the need for a standardized global response. The FED, the ECB and the Bank of England would be considered to be 3 of the largest and worst hit central banks around the world in this crisis but the need for a global response expands even beyond these three financial institutions.
Commercial banks can very easily move their tax residency from country to country to avoid strict laws such as capital buffer limits and tax rates. After all without our low 12.5% corporation tax, it is perceived that the “Celtic Tiger” of the 1990’s may not have happened. So without a global response to the already over powerful and “systematically” important Financial Institutions, are we not just encouraging them to play countries off one another to get the best deal for themselves? This may give high levels economic recovery to countries with the most lenient laws and regulations but also exposing these countries to significant risk of another boom to bust situation. This global response must stem from somewhere and I believe it is in the hands of the G20 states if it is to happen. France took over as chair of the G20 around 2 months ago and it must implement decisions if we are to avoid another severe financial crisis. As reported in the Financial Times on 24 of January 2011, “It has to implement decisions, deepen interaction between countries and institutions to create fairer and more legitimate global governance”. According to this FT article, we must provide a united front and we believe this to be true. We need greater co-ordination and conversation between governments and finance ministers in particular. We need central banks to co-ordinate more often in their response to the crises.

Role of Monetary Authorities / Role of A Well Functioning Banking System

Again, of course the role of monetary authorities will be affected by the economic turbulence, and it is essential that changes in their roles be made to help avoid and best deal with any such turmoil in the future. The stuttering and un-cohesive reactions of the ECB, Federal Reserve and Bank of England (BOE) etc. need to be a thing of the past. Specifically in terms of the BOE, we feel there needs to be greater coordination between, the FSA, HM Treasury, and BOE (if not a more drastic unification of the three) in order to quicken reactions to any future credit crisis etc. Although the BOE justified their non-interventionist approach by saying it was discouraging risk taking, I feel that the delay in their response was in some part down to a lack of coordination between the three. All central banks appeared to take philosophy of former Federal Reserve chairman Alan Greenspan that of concentrating solely on controlling inflation/ interest rates and ignoring the difficult to identify asset bubbles until they had burst. This is clearly evident from the ad-hoc changes made to operational framework by the Central Banks, such as the introduction of SLS (special liquidity scheme) by the BOE and TAF (Term Auction Facility) by The Federal Reserve. They were clearly not prepared to deal with the crisis. In the future it is essential that they adopt a strategy of identifying asset bubbles and stress testing ‘what if?’ scenarios in order to properly prepare for different and worst case scenarios. This could also be achieved by having increased global coordination between the main central banks, which would enhance transparency and would also allow for the provision of a 3rd party entity to be set up to take on this role identifying and stress testing. By allowing the failure of banks such as Lehmann Bros., one would hope that this would deter banks from taking unnecessary risk in the future, however we would have liked to have seen a stricter approach from the central banks in the bailouts putting a greater fear on banks for the future. Being viewed as a lender of last resort can allow banks the propensity to take extraordinary risk knowing they will be bailed out if it all goes wrong. Thus we cannot completely rule out the future possibility of this occuring once again. In the immediate future the importance should be placed on a proper exit strategy for the central banks from their quantitative easing strategies. They all now hold huge amounts of assets and if they cannot recoup the capital for these assets as the economy recovers, there is the potential to be faced with huge inflation caused by the increased liquidity in the market. In the case of the ECB they recently announced plans to put off the next phase of their exit strategy and will continue to provide an un-quantified number of loans for the next 3 months through the repo-markets. In our opinion there needs to be a limit on the loans of the ECB, as in time their deteriorating balance sheet could spark off a greater widespread panic and thus lead to an even deeper crisis. Of course the use of reverse repos is an essential tool in any monetary policy during a crisis, but there needs to be more preciseness and control over both the lending and exit policy of the quantitative easing.

Basel III
As with everything, with Basel III we need to look at our previous failings if we are to move on and learn from our mistakes. The main contributor of Basel II to the financial crisis was of risk weightings. Banks were required to hold more capital in reserve against riskier assets, whilst low risk assets needed little or no capital to be held. It is as a result of this that we saw the boom in securitizations, and the structured finance craze in order to use the CRAs to manufacture risk free assets out of risky pools. It is essential that Basel III address this risk weighting issue, this will be done by increased risk weights on ABSs etc., doing this will ensure a commensurate amount of capital to support relevant risks. There will also be a requirement that banks conduct a more thorough credit analysis of externally rated securitization, a sort of double check that although will increase confidence will more than likely result in the cost being passed onto the consumer through higher premiums. As well as this, in our opinion it is essential that the role of repos in the financial crisis will also need to be looked at when laying out Basel III. During the crisis very volatile asset prices resulted in increased uncertainty on the value of collateral, particularly less liquid collateral. Due to this repo markets were quickly affected and began to show signs of strain. Activity in repo markets moved to the high end collateral only, cutting credit lines. Due to this it is important that Basel III puts a limit on the amount a financial institution’s balance sheet is funded by repos. The dependency on repo financing must lessen, as it is unsustainable, being too heavily impacted during times of economic uncertainty. The main long-term goal of Basel III will be to reduce loan to deposit ratios of banks, such that the banks will be using more of their deposits to lend and less debt capital. Banks will be required to increase levels of capital, buffers and liquidity. The buffers should be built up in good times that can be drawn from in periods of stress. Whilst the introduction of the liquidity coverage ratio and the net stable funding ratio will prevent banks having liquidity issues in both the short and long run. However there is a massive opportunity cost to holding back all this extra capital, and in an ever more competitive banking market banks will be doing anything to increase their return on capital. In our opinion this could lead to banks seeking out different means of risk free lending such as AA or AAA sovereign bonds that still have a zero risk weighting. If this was to occur we could see ourselves in a very similar if not worse situation down the line. As such, we feel there is not one set of definitive rules that can be put in place. Dynamic regulation and monitoring is key, as banks will continue to try and find that elusive golden egg.

Conclusion
To conclude, it is clear that Obama isn’t the only one who needs change. It is clear that the recent economic turmoil will have a major impact in shaping the nature of financial markets in the future. From our above assessment it is obvious that in our opinion these changes will come mostly in the way of stricter regulations, and more tightly monitored markets and systems. Gone will be the days of banks with highly leveraged balance sheets, unmonitored trading of OTC derivatives, and untransparency between the central banks and also the banking system as a whole. We expect that this financial crisis will be the catalyst for some necessary changes to the global economic system in its entirity.

Bibliography
Blackboard Articles 1. Hedge Funds and the Financial CrisisBy: Houman B. Shadab
Professor, New York Law School * Adrian Blundell-Wignall, An Overview of Hedge Funds and Structured Products * Jan Hatzius, Beyond Leveraged Losses

International Trade * http://www.rieti.go.jp/en/papers/contribution/wakasugi/02.html

* http://www.metrocorpcounsel.com/current.php?artType=view&artMonth=May&artYear=2009&EntryNo=9651

Financial Times * CRA - http://www.ft.com/cms/s/0/9cf073b8-2337-11e0-b6a3-00144feab49a.html#axzz1DZUNVP1

* VaR - http://www.ft.com/cms/s/3/d625c854-0bf0-11df-96b9-00144feabdc0.html#axzz1BxpIvWFt

* Geo Political - http://www.ft.com/cms/s/0/82bc67ee-01f5-11e0-b66c-00144feabdc0.html#axzz1BxpIvWFt

* Monetary Policy - http://www.ft.com/cms/s/0/e7bb44aa-1ce7-11e0-8c86-00144feab49a.html#axzz1C2s6I0ab

Economist * Basel III - http://www.economist.com/blogs/freeexchange/2010/09/basel_iii
Reuters
* Basel III - http://blogs.reuters.com/felix-salmon/2010/09/12/basel-iii-arrives/

Bloomberg * Investment/commercial banks
(www.bloomberg.com/apps/news?pid=newsarchive&sid=atSsZ5Fp*xuY).