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"Real Financial Regulation Requires Laying the Foundation of a New Legal Order"

This article is based on an interview with Professor Katharina Pistor and Le Monde's Adrien de Tricornot.

LE MONDE | Feb. 2, 2014 |  Interview conducted * by Adrien de Tricornot

In the offices of Columbia University's Global Center in Paris, Katharina Pistor, Professor of Law, recently launched the Global Law in Finance Network, which also includes Frankfurt University and Oxford University. Professor Pistor responded to French newspaper Le Monde's questions about the challenges of financial regulation after five years of crisis.

She notes that nowhere have deep reforms really been carried out to address the causes of the debacle that followed the bankruptcy of Lehman Brothers. "The financial system has been transformed in the last thirty years. Yet no one has the political will to restructure it, unlike what was done in the 1930s. If we don't do that, we at least have to change the regulation system.... and that hasn't been done either," she points out.

At Columbia, Professor Pistor has led the Global Finance and Law Initiative for the past two years. Its aim is to lay the foundations of new legislation governing financial activity. She emphasizes that the current financial system has deep legal foundations. It refers to laws and regulations - on insurance, banking, financial products, etc. - which vary by country and are monitored by diverse agencies.

But financial activity also depends on contracts, including reciprocal commitments, obligations, particularities, and possible conflicts between legal regimes. "And new forms of financial instruments have been invented, of course depending on different forms of regulation," she emphasizes.

On paper, everything seems neat. In reality, "the paradox of finance is that there remains a fundamental uncertainty about the future, even if we try to reduce it as much as we can," insists Professor Pistor.

All the ingredients are already there before a crash. "The nature of contracts between financial players has the potential to destroy the system. However this fact is not acknowledged. What is not understood is that ultimately someone has to bear the risk, as was demonstrated by the bankruptcy of AIG," the American insurance giant which Washington had to bail out.

An "accident" therefore remains unthinkable, its consequences, too. But for Professor Pistor "we must consider the relations of power within the financial system, which is inherently a grouping of relationships: 'An asset on my balance sheet is a liability on yours.'"

When everything spins out of control "we have to find someone who has a better balance sheet to bear the risk, and we turn towards central banks, which are public entities. This is the heart of the system, just as governments and parliaments can make the regulations more flexible," reminds Professor Pistor. "Finance as a system is legal, paradoxical, and by its very essence a hybrid between the public and private sectors. But this last point is absent from debate because it still works on the old logic of an opposition between liberalism and socialism," she explains.

Responding to "Innovations"

In the absence of a comprehensive overhaul of the financial system, Professor Pistor advocates a series of reforms of the regulatory system. "We have to reconnect regulators among themselves to permit them to act," she says. This depends on greater coordination between different regulatory authorities (banks, insurance, markets) and countries: "The division of labor between regulators doesn't permit them to effectively fight shadow banking or to impose prudential rules on CDSs [credit default swaps], especially concerning sovereign debt, which are beyond the regulation of insurance."

Next, she advocates an ex ante review of financial contracts, with the regulatory authority having access to all data to determine who will bear the risk in case of crisis. She believes, moreover, that all financial products should be traded on organized markets. And that leeway must be given to regulators to respond to legal innovations "when competitive advantages are found in loopholes."

Certainly, the system will not function ideally. Professor Pistor evokes the difficulty of getting global institutions to come to agreement on prudential rules under Basel III, and their tendency to resolve known and past crises rather than those to come. She would like to insist that a wake up call is necessary to at least reduce risk.

Ultimately, the role of central banks--the last bulwark against the collapse of the financial system--if it is legitimate in a crisis, raises the question of the democratic validity of their choices.

"To not intervene makes life easier for political authorities, but it makes the financial system more powerful, because it has a massive political influence," emphasizes Professor Pistor, who is also working on a book about the Eurozone crisis.

 
* Note: This article was published in French by the daily newspaper, Le Monde, and has been translated into English.