DAVID A. CHAIKIN, University of Sydney - Faculty of Economics and Business
Email: david.chaikin@sydney.edu.au

The traditional method of combating financial crimes such as money laundering is the use of prescriptive legislation. A new idea is that risk concepts may be applied to understanding the phenomenon of money laundering and in devising strategies to minimise money laundering. In Australia, financial institutions have implemented a Risk-Based Approach to money laundering by devising Anti-Money Laundering/Counter-Terrorism Financing programs. Financial institutions are expected to identify the risks of money laundering arising from their customers, products/services, distribution/delivery systems and the countries/ jurisdictions in which they operate or do business. They are also required to analyse the risks in relation to their specific circumstances and apply a risk management strategy to reduce those risks. The challenge is that Risk-Based Approaches can only minimise the potential risks of money laundering at best; they cannot provide any guarantee that money launderers will not use the product or services of a financial institution. The money laundering risk remains even in circumstances where a financial institution complies with the regulatory requirements and applies best practice in risk management. Nevertheless, the Risk-Based Approach offers financial institutions the most efficient method of setting priorities and allocating resources to combat money laundering.

MARC AUBOIN, World Trade Organization (WTO)
Email: Marc.Auboin@wto.org

The paper discusses a number of issues related to the treatment of trade credit internationally, a priori (treatment by banking regulators) and a posteriori (treatment by debtors and creditors in the case of default), which are currently of interest to the trade finance community, in particular the traditional providers of trade credit and guarantees, such as banks, export credit agencies, regional development banks, and multilateral agencies. The paper does not deal with the specific issue of regulation of official insured-export credit, under the OECD Arrangement, which is a specific matter left out of this analysis. Traditionally, trade finance has received preferred treatment on the part of national and international regulators, as well as by international financial agencies in the treatment of trade finance claims, on grounds that trade finance was one of the safest, most collateralized, and self-liquidating forms of trade finance. Preferred treatment of trade finance also reflects the systemic importance of trade, as in sovereign or private defaults a priority is to "treat" expeditiously trade lines of credits to allow for such credit to be restored and trade to flow again. It is not only a matter of urgency for essential imports to be financed, but also a pre-condition for economic recovery, as the resumption of trade is necessary for ailing countries to restore balance of payments equilibrium.

The relatively favourable treatment received by trade finance was reflected in the moderate rate of capitalization for cross-border trade credit in the form of letters of credit and similar securitized instruments under the Basel I regulatory framework, put in place in the late 1980s and early 1990s. However, as the banking and regulatory communities moved towards internal-rating based and risk-weighted assets systems under the successor Basel II framework, a number of complaints emerged with respect to the treatment of trade credit – particularly in periods of crisis. Issues of pro-cyclicality, maturity structure and country risk have been discussed at some length in various fora, including in the WTO at the initiative of Members. Part of the issue was that Basel II regulation was designed and implemented in a manner that, in periods of banking retrenchment, seemed to have affected the supply of trade credit more than other potentially more risky forms of lending. With the collapse of trade in late 2008 and early 2009, the regulatory treatment of trade credit under Basel II clearly became an issue and was discussed by professional banking organizations, regulators and international financial institutions. A sentence made its headway into the communiqué of G-20 Leaders in London in April 2009, calling upon regulators to exercise some flexibility in the application of Basel II rules, in support of trade finance. As the issue of removing the obstacles to the supply of trade finance spread became part of the public debate, discussions with respect to the regulatory treatment of trade finance in the context of the making of "Basel III" rules are now raising political attention.

Part of the underlying problem regarding the design of regulation of trade finance is that banking regulators may not have enough understanding of the way that trade and trade finance operate in practice. In turn, the banking community has made insufficient progress in explaining these issues to regulators and in providing evidence about the high level of safety and soundness of their activity, in collecting statistical information and even in defining clearly what comprises trade finance. This paper aims at clarifying such issues. The WTO, in its role as an "honest broker", is trying to help the parties concerned, and has been asked from time to time to act as a go-between between the two communities, in order to clarify issues. Section 1 looks at the overall Basel framework and its evolution over time, with particular emphasis on the regulation of trade finance. Section 2 looks at issues raised in the WTO context by the trading and trade finance communities, be it by WTO Members or by experts, and how this has helped to clarify some of the disputed issues. Section 3 raises a number of questions which need clarification from the trade finance community for regulators to be able to better capture the reality of trade finance operations, and allow them to regulate with full understanding of its implications.

ROMAN A. TOMASIC, Durham University - Durham Law School
Email: r.a.tomasic@durham.ac.uk

We have reached a turning point in our efforts to regulate banks and financial institutions by resort to current risk-based models and regulatory structures. As is evident from failures during the global financial crisis that burst upon the scene in later 2007, the use of these risk based and self regulatory models has been seen by many to be seriously flawed. This failure may be attributed to many causes, such as flawed assumptions of rating agencies, the limits of model building as an exercise, and the ease with which such efforts have been compromised by behavioural and political factors that influence markets. These behavioural factors include the power of market euphoria and the influence of perverse incentives which have driven excessive risk taking. Political factors have included the uncritical commitment to self-regulation and the capacity of markets to regulate themselves. Whilst risk is an inherent feature of modern times, the question that arises here is the degree to which banking regulation should depend exclusively upon the use of narrow (an inevitably imperfect) mathematical risk models and the extent to which these need to be supplemented by the application of legal rules as well as other regulatory techniques that have emerged from the study of corporations and professionals. However, the limits of law as a mechanism for social ordering should also not be over-estimated. Other factors, such as the existence of mutual trust and an appreciation of wider stakeholder interests are also important ingredients of any effective regulatory system. This has led to calls for more responsive forms of regulation, although little of this work has focussed much upon the banking and finance sectors. This paper explores these themes which call for a more nuanced approach to corporate law and regulation of banks and other financial institutions.

LARS NORDEN, Rotterdam School of Management, Erasmus University
Email: lnorden@rsm.nl
MARTIN WEBER, University of Mannheim - Department of Banking and Finance, Centre for Economic Policy Research (CEPR)
Email: weber@bank.bwl.uni-mannheim.de

We investigate whether price information from credit default swap (CDS) markets is useful for assessing the default risk of large banks during 2001-2008. We exploit the fact that there are two liquid trading segments for banks as underlyings: one for CDS on senior bank debt, and one for CDS on subordinate bank debt. Using both CDS spreads for the same bank makes it possible for us to derive daily market-implied values for two risk parameters jointly. Comparing an international sample in the pre- and post-crisis period, we show that the loss given default on senior bank debt increases from 56% to 61% and the probability of default increases from 0.34% to 1.22%. We also find that both CDS spreads contribute significantly to price discovery but transactions costs, as measured by the relative bid-ask spread, are lower in subordinate CDS. After the beginning of the financial crisis, we find a lead-lag relation between senior and subordinate CDS, and subordinate CDS loose their transaction cost advantage. Our results highlight that CDS markets convey differentiated information on banks’ default risk that is suited to play an important role in enhancing market discipline.

BRUCE E. ARONSON, Creighton University - School of Law
Email: aronson@creighton.edu

This Article consists of an introductory essay and an edited transcript of an unusual panel discussion on implications of the financial crisis. A panel of experts composed of prominent corporate and banking law scholars, local financial industry executives, and a bank regulator convened at a recent symposium held at the Creighton University School of Law and engaged in a moderated discussion on applying lessons from the first year of the financial crisis to basic considerations underlying financial regulatory reform.

There was a surprising degree of agreement on a number of basic issues between the “pro-regulation� academics and the “pro-market� business executives. In particular, both groups consistently cited the importance of the structure of financial incentives and the necessity of aligning such incentives with organizational goals as both an important cause of, and potential solution to, the financial crisis.

The panel discussion covered six broad topics: (1) causes of the financial crisis, (2) government bailouts and market support, (3) historical analogies and lessons,(4) foreign banks and globalization, (5) systemic risk and its regulation, and (6) consumer issues and executive compensation. In each of these areas, the differing perspectives and experiences of the participants and the interaction among them resulted in thought-provoking discussion on fundamental issues of financial system reform.

KEVIN SLEEM, UNISA
Email: kevinsleem@yahoo.com

A theoretical role for the government in the financial markets consists of: regulation (passive rules), intervention (active discretion), and their personal financing needs. Three of the most important regulatory rules for maintaining a stable economy are: a clear understanding of the fundamental role of the financial intermediary (saving, lending, and risk hedging), the use of interest rate caps, and implementation of an effective profit allocation scheme. To measure the personal use of the financial markets by governments, their presence on foreign exchanges is examined to note discrepancies from the theoretical norm. A government listing guide is provided that details the listing preferences of foreign governments onto stock exchanges. The preferred foreign exchanges for governments are: Frankfurt, Luxembourg, London, and Switzerland.

KENT MATTHEWS, Cardiff University Business School
Email: MatthewsK@cardiff.ac.uk
OWEN DAVID MATTHEWS, affiliation not provided to SSRN

The positive relationship between bank CEO compensation and risk-taking is a well-established empirical fact. The global banking crisis has resulted in a chorus of demands to control bankers' bonuses and thereby curtail their risk-taking activities in the hope that the world can avoid a repeat in the future. However, the positive relationship is not a causative one. In this paper we argue that an implicit too-big-to-fail policy provides the incentive for banks to take excessive risks and design compensation packages to deliver high returns. A credible no-bailout policy will have a better chance of curbing excess risk-taking than controlling bankers' compensation.

HONGBIN CAI, Peking University - Guang Hua School of Management
Email: hbcai@gsm.pku.edu.cn
HONGBIN LI, Chinese University of Hong Kong - Department of Economics
Email: lhongbin@cuhk.edu.hk
LI-AN ZHOU, Peking University - Guang Hua School of Management
Email: zhoula@gsm.pku.edu.cn

Renegotiation plays an important role in contract theory, but the empirical study of renegotiation is almost non-existent in the literature. Using a unique dataset from the Chinese banking industry, we find that the large majority of managerial incentive contracts are renegotiated after performances are realized. We develop a model of contract renegotiation where supervisors and managers sign incentive contracts and then renegotiate them. In the unique equilibrium of the model, incentive contracts are almost always renegotiated ex post. Even though renegotiation is fully anticipated, incentive contracts affect performance. The predictions of the model find strong support from our empirical results.