Lorenzo Bini Smaghi: Legal system and financial markets
Opening remarks by Mr Lorenzo Bini Smaghi, Member of the Executive Board of the
European Central Bank, at the conference "Legal issues related to the financial markets",
Frankfurt am Main, 26 October 2007.
* * *
Ladies and Gentlemen1:
It is with great pleasure that I open this conference on a topic which is of fundamental
importance and also of some additional interest in the most recent times in the light of the
market turmoil, as I will explain in a moment.
1. Legal systems and economic growth
The economics literature has emphasised that institutions in general, and the legal system in
particular, represent a fundamental determinant of economic growth, especially in connection
to financial development.2 By the "legal system" I mean not only legislation and rule books,
but also the infrastructure of the civil courts and the market regulators.
In cross country analyses, the quality of institutions and the efficiency of the legal system
often overshadow other classical determinants of growth such as the availability of national
resources (which in itself tends to be more a curse than a blessing3), country size, physical
capital, and so on. This is a consideration that we, as economists, perhaps need to take
more seriously into account than we currently do.
The link between law and finance is inextricable. It would be unconceivable to think of a
financial system and indeed of any financial instrument without a legal system to support it.
The keyword for economists in this context is "asymmetric information": the lender, in
particular, does not know if the borrower is trustworthy or not, or whether the investment
project the latter is undertaking is worthwhile. A financial asset is ultimately a claim in the
form of piece of paper or even, and increasingly so, an account entry. In any credit
relationship - and this includes almost any economic transaction beyond simple barter - the
possibility of default is always looming and this inherent complication cannot be solved
without a precise system of norms that protects both the creditors and the debtors.
For the creditor to consider entering in a financial relationship, the legal system must not
make it too easy for the debtor to walk away from his obligations. At the same time, the legal
system cannot be too taxing for the debtor, as Shakespeare's Merchant of Venice reminds
us. The legal system has thus to develop along a fine line between protecting the rights of
the borrowers as well as those of the lenders. No wonder that developing a sound legal
system to support financial markets is a very complicated matter and we hope to learn
something from today's conference.
2. Legal systems and competitiveness of financial centres
Fundamentally, the legal system should ensure that contract and property rights are
sufficiently clear and predictable; if there is a dispute, participants in the contract do not feel
the need to take legal action unless as a last resort. Moreover, if there is litigation, the court
is independent and able to resolve the claim effectively and in a reasonable time.
Furthermore, the judgment, once delivered, has to be quickly enforced.
To underline the importance of this aspect let me give the example my own country. There is
a growing literature suggesting that one of the reasons for the relatively slow pace of
financial development in Italy is the slowness of the civil courts, with the result that, for
example, mortgage debt is still a fraction of what it is typically in other advanced countries.4
At this point it should be clear that an efficient legal system is a key ingredient of
competitiveness among financial centres. One of the reasons of the traditional lead of US
financial markets over Europe (and the rest of the world) is greater standardisation of legal
norms and systems, while the European financial system is still characterised by
considerable fragmentation of legislation, regulation and enforcement.
Without a proper legal system, it becomes harder to trade in almost any financial instrument.
Two distinct effects may be considered. On the one hand, yields may rise and consequently
asset prices fall. In other words, asset yields may incorporate a "legal risk premium". It is
interesting to note that under the Basel II system legal risk is a part of operational risk, which
implies that it is taken seriously by the regulators. On the other hand, an inefficient legal
system may simply lead business to move elsewhere, namely influence the quantities rather
than prices.
The importance of the legal environment was recognised most notably in the January 2007
Bloomberg-Schumer report, "Sustaining New York's and the US's global financial
leadership", which reported that "a firm and predictable legal environment was the second
most important criterion determining a financial center's competiveness."
An efficient legal system does not, of course, always imply more (and more restrictive) rules.
A balance needs to be struck between restrictive rules and a lighter approach, which may be
important for the overall competitiveness of financial centres. The current debate about the
competitiveness of the US marketplace (in particular in relation to its British competitor)
emphasises that this balance is not always easy to find.
3. Financial globalisation and innovation
Let me now turn to some issues related to the impact of financial globalisation and innovation
on legal systems. In my opinion the protection of the rights of debtors and creditors becomes
more - and not less - difficult with the development of financial markets, both in a
geographical sense as well as in the range of available products (financial globalisation and
innovation). The challenges posed by financial globalisation are not difficult to understand: a
financial instrument originated in country A, traded in country B by an intermediary whose
headquarters are in country C and purchased by an investor who is resident in country D, to
what legal system will it be subject to? How will the citizen of country D be able to enforce his
rights, which courts will be responsible for any dispute, what kind of legal redress will it be
available on citizens of country A and B? These are questions that lie at the very heart of
financial globalisation. From the simple observation that the bulk of cross border capital flows
still takes place among advanced countries, one may easily surmise that such legal
uncertainties (arguably more important in emerging economies) play a fundamental role in
the allocation of financial flows and financial capital worldwide.
Over the last years, quite a number of initiatives dedicated at enhancing legal certainty
regarding such cross-border financial transactions have been undertaken on a global as well
as on a European level. International bodies dedicated to the harmonisation of laws [such as
UNIDROIT or UNCITRAL] have turned the focus of their activities on financial market issues,
such as secured transactions or cross-border holdings and transfers of securities. This focus
is mirrored by a multitude of complementary initiatives on the European level, where I would
just like to mention the various legislative projects aimed to enhance the integration of the EU
financial markets that were combined in the so-called Financial Services Action Plan as well
as the more recent attempts to enhance efficiency and integration in the EU post-trading
industry, that is the clearing and settlement of cross-border securities transactions.
4. Lessons of the recent market turmoil
Turning to more recent events, the emergence of structured products, where the creditor is
separated from the debtor by a complex financial infrastructure that transforms and
repackages the underlying asset, might create significant legal challenges and this might
become an important concern in the light of the recent market turmoil. Who pays if debtor A
defaults, in case his debt has been repackaged by bank B, sold to the non-bank intermediary
C and finally to investor D? These are legitimate questions that need to be addressed
carefully. But answers have to be given if the uncertainties surrounding the current
environment are to vanish.
As you know, a number of policy initiatives have been launched at the global level since the
summer, for instance by Financial Stability Forum5 or by the Porto informal ECOFIN6 and it
is still difficult to anticipate precisely the legal aspects which will be examined more
particularly by the various international and European fora and bodies involved in this
discussion. However, these initiatives provide an indication of possible legal considerations
which might emerge, in particular in the European context.
Legal certainty should go hand in hand with transparency. The focus on the transparency of
complex financial instruments, of institutions and vehicles and on the appropriate disclosure
of information on securitised debt and other structured financial products indicates that there
is a need for regulatory and supervisory authorities to have a closer look on the legal
frameworks applicable to securitisation transactions and market standards and how special
purpose vehicles are currently regulated and supervised in the various EU Member States
and at also at the international level. The report of the European Financial Markets Lawyers
Group (EFMLG) of May 2007 on legal obstacles to cross-border securitisations in the EU7
contains recommendations for further convergence of securitisation laws in the EU and
invites the Commission to consider the adoption of a EU directive on specific legal aspects of
securitisations which would enable Member States to adopt a certain number of principles
common to all jurisdictions to ensure a high level of transparency, efficiency and legal
certainty with regard to securitisation transactions.8
5
See Financial Stability Forum, FSF Working Group on Market and Institutional Resilience, Preliminary Report
to the G7 Finance Ministers and Central Bank Governors, 15 October 2007, available at:
http://www.fsforum.org/publications/publication_24_88.html.
6
The informal ECOFIN of Porto considered that, while enhancing market efficiency, financial innovation also
raises obvious challenges to the regulatory and supervisory authorities. In this context, the Economic and
Financial Committee (EFC) was invited (i) to review how to further improve transparency of complex financial
instruments, of institutions and vehicles, as well as how to improve valuation processes, risk management and
liquidity stress testing. The EFC is also invited to consider the role of rating agencies in structured finance.
7
Available at www.efmlg.org. In its Report on Financial Integration in Europe (March 2007), the ECB indicates
that it has been active in various initiatives of the EFMLG to overcome legal barriers to financial integration,
such as through the closer harmonisation of securitisation laws in the EU and contributed in particular to the
EFMLG report on cross-border legal obstacles to securitisation.
8
In two opinions concerning draft laws on securitisation in Luxembourg and France, the ECB indicated that it
stressed that, looking beyond the Commission's Financial Services Action Plan, it saw merit in a strategy of
increased harmonisation in the area of securitisation at the EU level (See in this respect ECB Opinion
BIS Review 122/2007
In the context of the current financial turbulence, another issue which is often mentioned is
the methodologies followed by rating agencies in the field of structured finance and the need
to benefit from legal opinions assessing in an appropriate manner the legal risks related to
the securitisation deal's core components and identifying properly the rights of investors.
At this point, let me not abuse of your time any longer. I hope that I have effectively conveyed
the message that we, as policy-makers, care that the global financial system is put on a solid
legal footing. I wish you all the best for this conference in contributing to this endeavour.
Thank you for your attention.