THE FINANCIAL CRISES: CAUSES AND CONSEQUENCES AND THE SOUTH AFRICAN RESPONSE

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1 THE FINANCIAL CRISES: CAUSES AND CONSEQUENCES AND THE SOUTH AFRICAN RESPONSE I. INTRODUCTION TSHEGO COLLET NYOKA 1 LLM Candidate, School of Law, University of the Witwatersrand The financial sector is viewed by the free market as the foundation of any society. The financial sector acts as an environment for a free, dynamic and competitive economy. 2 The stability of any society relies upon that society s financial sector s ability to perform its duties. The duties of the financial sector include, but are not limited to, mobilising the flow of funds between investors and borrowers 3, acting as a mechanism for companies to sell securities and finance expansion 4, and encouraging systematic risk-taking and rewarding profitable investment. 5 The foundation of the sector is financial regulation. Some argue that there is no universal definition for financial regulation 6 however one may explain it as 'obligations imposed by public law designed to induce individuals and firms to outcomes which they would not voluntarily reach, but are in the public interest'. 7 Mutenga is of the opinion that the rationale for regulation is to protect the consumer and maintain market stability. 8 So if regulation of financial markets isn t present the markets would not operate in a stable and sustainable manner. Levine argues that a systematic failure of financial regulation is the cause for the financial crisis. 9 She further argues that financial regulation requires an informed, expertly staffed and independent institution which views and assesses financial regulation from a public's perspective. 10 It must be noted that this institution would have to operate within a regulation system. Failure of this crucial sector can cause major instability which can result in the breakdown of society. This was clearly illustrated by the financial crisis. This catastrophic breakdown in the finance sector caused an international wave of unemployment and homelessness, especially in China and the USA. The crisis can be briefly described as 'the bursting of the housing market bubble in late 2007,the ensuing collapse in the sub-prime LLB (Pretoria) LLM - Commercial and Business Law (Witwatersrand). 2 FR Malan et al The Reserve Bank, Banks, and Clearing Houses in South African Law: Part 1 (2001) 13 SA Merc LJ 35 at Banking and Finance Lecture Presentation, Seminar 1 (2015) at 2. 4 Ibid at 2. 5 Ibid at 2. 6 S Mutenga "Theory of Risk and Insurance Markets - CIN 5101" (2016) [Presentation] at 1. 7 Ibid at 1. 8 Ibid at 1. 9 R Levine 'The Governance of Financial Regulation: Reform Lessons from the Recent Crisis' (2012) 12.1 IRF 39 at Ibid at 39.

2 mortgage market and related financial markets and the subsequent collapse of the Lehman Brothers in 2008 which resulted in a sharp increase in risk premia around the world'. 11 This article accepts this definition as set out in the IEP working paper. This article aims to critically discuss the financial crisis; it will also assess the causes and consequences of the crisis. This article will further discuss South Africa's regulatory and institutional responses aimed at averting the recurrence of a similar crisisand establishing whether South Africa's move to the Twin Peaks structure is the best structure to avoid a systematic failure in future. II. THE FINANCIAL CRISIS The global recession is regarded as the most severe economic crisis since the great depression. 12 A wave of fear following the fall of Lehman Brothers 13 resulted in the crisis. Banks refused to continue lending to one another which raised the risk premium for interbank lending to a staggering five percent from almost zero percent. 14 Large CAPEX projects were stalled, the corporate sector could not continue borrowing, and trade credit for investment goods and manufacturing of durables collapsed. 15 The crisis also devastated the United States employment rate. The unemployment rate increased from 4.4 percent to 7.2 percent in , the rate reached its peak at 10.1 percent in October (a) the causes of the financial crisis McKibben and Stoeckel trace the events leading to the crisis from the greatest financial advances and setbacks in the past decade. The large global events, like the bursting of the dotcom bubble and the rapid growth of China, reshaped the pattern of world trade. 18 This caused differences between savings and investment in China and large deficits in the USA. 19 Other key events can be said to have contributed to the crisis and can be regarded as the base to the crisis. The Asian financial crisis in 1997 led to large current account surpluses which had to be invested offshore to keep nominal exchange rates low. 20 Capital was moved to US dotcom stocks and drove up equity prices. 21 This led to the bursting of the Dotcom bubble 11 WJ McKibben &AStoeckel 'The Global Financial Crisis: Causes and Consequences' (2009) IEP at R Jagannathan et al Causes of the Great Recession of : The Financial Crisis is the Symptom Not the Disease! (2009) NBER at WJ McKibben &AStoeckel 'The Global Financial Crisis: Causes and Consequences' (2009) IEP at Ibid at Ibid at R Jagannathan et al Causes of the Great Recession of : The Financial Crisis is the Symptom Not the Disease! (2009) NBER at Ibid at WJ McKibben &A Stoeckel 'The Global Financial Crisis: Causes and Consequences' (2009) IEP at Ibid at

3 in The US Federal Reserve eased monetary policy to counter possible inflation 23, but the introduction of easy credit and a rising housing market caused risk premia to hit low levels. 24 Leveraged deals became common and regulatory oversight became a dominant feature in the markets. 25 Commodity prices rose and an increase in inflation caused monetary authorities to tighten policy from 2004 to McKibben argues that these events all led to the baseline of the crisis as they reshaped the world economy. Jagannathan argues that the instability of the ever growing global economy also contributed to the financial crisis. This rapid growth has resulted in the inability of emerging economies to integrate savings created through financial investment due to inadequate financial markets 27, it has caused an inability by exchange rates to absorb shocks caused by the focus on immediate national objectives 28 and the breakdown of checks and balances of financial institutions caused by large inflows of money. 29 There seems to be many factors and events which led to one of the biggest financial catastrophes in history. The inconsistency in regulation in 2001 to 2006 played a crucial role. This article will now assess what constituted the financial crisis. (b) characteristics and consequences of the financial crisis The financial crisis can be characterised into three major occurrences. Firstly the bursting of the housing bubble causing a reallocation of capital and a drop in consumption 30, secondly a sharp rise in equity risks resulting in a decline of private investments and a decline in demand for durable goods 31 and thirdly a reappraisal of risk by households causing them to discount their future labour income, increase savings and decrease consumption. 32 The crisis devastated the financial markets and caused unemployment at a considerable scale. Most importantly it helped states, including South Africa, realise the faults in regulation and supervision of the finance sector and introduced a re-evaluation of their regulatory models. In order to understand the models favoured in each state we must assess each regulatory model. III. SUPERVISORY AND REGULATORY MODELS FOR THE FINANCIAL SECTOR As discussed above it seems that the inconsistency in regulation was a contributing factor to the occurrence of the crisis. In order to curb the reoccurrence of the recession, jurisdictions Ibid at R Jagannathanet al Causes of the Great Recession of : The Financial Crisis is the Symptom Not the Disease! (2009) NBER at Ibid at WJ McKibben &A Stoeckel 'The Global Financial Crisis: Causes and Consequences' (2009) IEP at Ibid at 6. 32

4 looked into finding clear and consistent models for regulation. The four models which exist can be regarded as most effective depending on the jurisdiction which it is introduced. This article will look at the reasons behind regulation in the finance sector and will assess each regulation and supervisory model and their advantages and disadvantages. (a) reasons for the existence of regulation in the finance sector Regulation in the finance sector was introduced under the pretext of financial stability and certainty of market participants 33. Regulation in the financial sector aims to avoid the collapse of banking systems and protect consumers 34. On the basis of stability, regulation impacts the size, structure and efficiency of the financial system. 35 Further, it impacts the business operations of financial institutions 36 and its competitive conditions 37. Depending on its implementation, regulation can be harmful or useful to the finance sector. (b) models for regulation and supervision There are four models for the supervision and regulation of the finance sector; the Institutional Approach, the Functional Approach, the Integrated Approach and the Twin Peaks Approach. The Institutional Approach is a classic form of financial regulation. 38 It is a legal-entity driven approach. This means that the institution s legal status will determine which regulator is tasked with overseeing activities relating to the daily running and conduct of the said business. 39 The regulator will also determine the scope of the institutions business activities. 40 The Functional Approach requires regulation to be determined by the business activities that the entity undertakes it does not consider the entity s legal status. 41 Each business activity may have its own functional regulator. 42 A functional regulator would be responsible for safety and soundness as well as business conduct regulation. 43 The Integrated Approach focuses on the use of a single regulator in charge of the safety and soundness of the business as well as conduct of business regulation for the entire financial sector L Swart Understanding the South African Financial Markets: An Overview of the Regulators (2010) OBITER 619 at H Falkena et al Financial Regulation in South Africa (2001) 2 nd edition at Preface. 35 Ibid at Preface Group of 30 'The Structure of Financial Supervision: Approaches and Challenges in a Global Market Place' (2007) at Ibid at

5 The Twin Peaksmodel is based on the idea of regulation as an objective. 45 It requires the separation of functions between two regulators, one regulator deals with the safety and soundness function while the second regulator focuses on conduct of business regulation. 46 With this approach there is also a separation between wholesale and retail activity, retail activity will generally fall under conduct of business regulation. 47 (c) assessment of the regulatory and supervisory models It must be noted that the success of a model is dependent on the regulators ability to achieve policy goals and cannot simply be considered from a theoretical perspective. However, in order to determine which model is most appropriate this essay will look at the advantages and disadvantages of each models. The Institutional Approach is regarded as redundant. The approach is based on business models which no longer exist in modern markets. 48. Businesses no longer deal with one distinct product or services but rather various categories. 49 Due to entities which have similar activities being regulated differently, there is a serious risk of inconsistency in regulation. 50 It seems this approach would be difficult to maintain. The Functional Approach seems to have the advantage of consistency, as a single expert regulator can apply consistent rules to a business activity despite the nature of the entity. 51 The challenge to this approach is making a distinction between activities which fall within the jurisdiction of a regulator. 52 Another disadvantage is the time and effort which must be put into regulation as a result of having multiple regulators which financial institutions must deal with. 53 There are other disadvantages to this approach. A regulator will generally lack sufficient information regarding all activities of an entity and will not be able to monitor systematic risk. 54 Systematic risk requires a regulator which has authority to mandate actions across the financial sector. 55 Group 30 argues that the Integrated Approach has been most popular in recent years. 56 The Integrated Approach streamlines regulation and supervision and does not have to consider jurisdiction lines. 57 This approach provides a comprehensive and broad view of the entity s Ibid at Ibid at Ibid at Ibid at

6 business allowing the regulator to look at the entity as a whole and affect necessary changes. 58 The Integrated Approach also has its shortfalls. Having a single regulator means no other agency can spot any issue which the single regulator failed to pick up. 59 Another shortfall is the dominance of a single regulator which results in the regulator having overwhelming power. Where there are multiple regulators, it results in regulators needing to outperform one another, this can lead to better regulation and supervision. 60 The Twin Peaks Approach to financial supervision has all the benefits of the Integrated Approach but it goes a step further by dealing with the conflicts between the objectives of safety and soundness regulation, consumer protection and transparency. 61 It allows each investor protection and market conduct mandates to receive singular focus. 62 This approach allows the employment of persons with expertise for their specific functions. Prudential regulators can hire persons knowledgeable in business and economics while business conduct regulators hire enforcement staff. 63 This approach also allows the development of arbitration and mediation systems, ombudsman programs, and other ways to ensure investor remediation. 64 The Twin Peaks model has been instituted in several jurisdictions including the Netherlands, Canada and Australia. Prior to the 2009 recession the model was not supported in the United Kingdom as it was viewed by the Bank of England as an unreasonable breakdown of its regulatory power and responsibilities. 65 Those opposed to the Twin Peaks model argued that prudential and conduct of business regulation dealt with the examination of similar issues and this would result in an overlap between the two regulators. 66 This would lead to two supervisors reaching the same decisions on similar matters. 67 After the crisis it became evident that despite the overlap on aspects like internal control and management prudential regulation must follow a different focal point. 68 A balance must be established between financial stability and consumer protection objectives. 69 The UK has come to embrace the Twin Peaks model despite its disadvantages. South Africa, like other jurisdictions, realised the need for consistent and clear regulation in the midst of the financial crisis. South African regulation is currently undergoing review and the Twin Peaks Approach is the direction currently being considered. It is important to first establish the current regulatory framework before looking at the response aimed at averting the reoccurrence of the crisis. This article will now assess South African regulation before and at the point of the crisis. IV. SOUTH AFRICAN POSITION AT THE POINT OF THE FINANCIAL CRISIS 58 Ibid at Ibid at Ibid at M Taylor The Road from Twin Peaks - and the Way Back 16:1 (2009) CILJ 61 at Ibid at Ibid at Ibid at Ibid at 90.

7 (a) regulation in South Africa South Africa currently has a diverse and rigid regulatory framework. According to Swart the South African market is an assortment of sources. 70 The aim for South Africa s regulatory framework is transparency. 71 It seems to mirror the functional approach to an extent. Various regulators focus on one aspect of regulation; either prudential regulation or market conduct regulation with the exception of the Financial Services Board which regulates both legs. (b) the regulatory authorities Regulators supervise and regulate various aspects of the financial market. 72 South Africa has several regulators. Each regulator is responsible for a section of the market. The most important regulators in the South Africa are the South African Reserve Bank and the Financial Services Board, which regulate the prudential leg of regulation, and Central Securities Depository, the Johannesburg Stock Exchange, the National Credit Regulator and the Consumer Commission. The Financial Service Board, National Credit Regulator and the Consumer Commission deal with market conduct regulation. The Financial-Services Board was established in It oversees the South African nonbanking financial services industry and creates the framework by establishing minimum standards and practices for the market. 74 The Central-Securities Depository is known as the Shares Transactions Totally Electronic (STRATE) and was created in collaboration with South Africa's four largest banks. It handles the settlement of equities, warrants and bonds for the JSE. 75 Its purpose includes the mitigation of risk and the improvement of South Africa's portfolio investment destination. 76 The Johannesburg Stock exchange is the single exchange in South Africa. It was established due to the discovery of gold in the Witwatersrand area in It allowed the trade of company securities at an international level. The Reserve Bank of South Africa is the central bank of South Africa. The central banks role is two-fold. It acts as the lead regulator of banks and controls all regulation and supervision of South African banks. 77 Its second function is the implementation of rules and procedures dealing with payment, clearing or settlement systems. 78 It can be difficult to single out a particular function of a central bank as characteristic of such an institution. 79 The banks 70 L Swart Understanding the South African Financial Markets: An Overview of the Regulators (2010) OBITER 619 at Ibid at Ibid at Ibid at Ibid at Ibid at Ibid at Ibid at J De Jager 'The South African Reserve Bank: An Evaluation of the Origin, Evolution and Status of a Central Bank (Part 2)' (2006) 18 SA Merc LJ 274 at 274.

8 functions include the implementation of monetary policy, the payment and settlement system, exchange control, bank supervision, and the control to issue and destroy the countries notes and coins. 80 In order to regulate banks efficiently the Reserve Bank is divided into several departments including the National Payment system department and the Financial Markets department. The National Credit Regulator is responsible for the regulation of the South African credit industry. 81 It is responsible for carrying out education, research, policy development, the registration of industry participants, the investigation of complaints, and ensuring enforcement of the Act. 82 Its duties also include collating industry information and registering credit institutions, credit bureaux and debt counsellors. 83 The National Credit Act requires the National Credit Regulator to promote and aid in the development accessible credit market which address the needs of historically disadvantaged persons, low income persons, and remote, isolated communities. 84 The Consumer Commission is responsible for the enforcement and carrying out of the functions assigned to it in terms of the Consumer Protection Act. 85 The regulator must ensure a fair, accessible and sustainable marketplace for consumer products and services 86, establish national norms and standards relating to consumer protection 87 ; provide for improved standards of consumer information 88 and prohibit certain unfair marketing and business practices. 89 South Africa has put measures in place to ensure efficient regulation. The focus however was transparency rather than consistency. (c) the impact of the financial crisis on South Africa It must be noted that South Africa was for the most part sufficiently protected from the crisis and did not suffer the devastating consequences of the recession to the extent of countries like the USA and China. However better regulation could result in complete protection against a crisis of this nature in future. To avert the crisis reoccurring South Africa aims to adopt the Twin Peaks model. V. SOUTH AFRICA'S RESPONSE TO THE FINANCIAL CRISIS 80 Ibid at M Vessio What Does the National Credit Regulator Regulate? (2008) 20 SA Merc LJ at Ibid at Ibid at Ibid at Department of Trade and Industry The National Consumer Commission available at accessed on 30 September

9 South Africa seemed to come out of the recession fairly unscathed. There was however loss of around a million jobs despite the economy s resilience to the crisis. 90 To avoid a ripple effect of that nature in future a policy document was drawn up in 2011 titled A safer financial sector to serve South Africa better. 91 This policy document proposed regulatory reform to the Twin Peaks model. The proposal was accepted and adopted by cabinet. 92 This section will look at the proposed framework of the model, its application and its enforcement in terms of the policy document. (a) implementing the Twin Peaks model in South Africa (i) General framework The Twin Peaks model will require the restructuring of regulators and their functions. The finance sector will have two regulators instead of the assortment of regulators currently in place. 93 There will be a prudential regulator; this will operate within the South African Reserve Bank, and a market conduct regulator which will be established from a restructured Financial Services Board. 94 This new regulatory framework aims to increase transparency as well as introduce regulation which is comprehensive, consistent, appropriate, intensive and intrusive, pre-emptive, proactive and outcomes-based. 95 (ii) Accountability framework The policy document further introduces a framework to ensure accountability of the regulators. 96 Under this framework government needs to ensure that regulators are operationally independent and can perform their duties impartially. 97 The prudential regulator will be accountable to the Reserve bank. 98 It will be required to provide information and interact frequently with the Minister of Finance on regulatory matters. It will also be required to table a report to parliament annually. 99 The market conduct regulator will be controlled by an executive management team. 100 This team will be appointed by the Minister of Finance. This team must also provide information and interact regularly with the minister and table a report to Parliament annually. 101 (iii) Prudential and market conduct frameworks The frameworks specific to prudential regulation and market conduct regulation must also be looked at in order to fully understand how the Twin Peaks model offers better protection against the effects of financial instability and market failures. 90 FRRSC Implementing a Twin Peaks Model of Financial Regulation in South Africa (2013) Ibid at Ibid at Ibid at Ibid at Ibid at Ibid at Ibid at

10 The prudential part of regulation will be based on 10 guidelines. This assignment will only look at the guidelines which deal with General application. Regulations will be created to proactively identify and address potential market failures. 102 Regulations will also be principlebased and aligned with international practices aimed at assessing risk. 103 Regulations will apply specifically to financial institutions and financial activities. 104 In order to avoid regulation becoming arbitrary all activities and financial products will be deemed to be permissible unless the regulator rules differently. 105 This regulator will also possess the authority to implement measures which correct regulatory transgressions. 106 The approach followed for prudential regulation is a risk-based approach. The supervisor or regulators severity will be dependent on the institutions risk level. 107 This risk level will also include the level of risk the institution exposes to the consumer as well as the financial sector in its entirety. 108 The main function of a risk based approach is to assess institutional performance by researching the level of risk of an institution based on its size, clients, activities, products and other factors. 109 There must also be research relating to the resilience of the institutions corporate governance, its risk management, control policies, systems, processes and procedures, and the quality of the institutions board and senior-management control. 110 The risks related to the institutions capital and reserve funds. 111 This approach also requires supervisors to determine how institutions identify, evaluate, monitor and control material risks. 112 Supervisors also need to review policies, systems, and procedures institutions use to manage risks especially those dealing with capital funds, reserve funds and prudential measures. 113 Lastly they must make sure they have and retain adequate resources. 114 Regulators will also consult and inform all parties about imminent changes relating to regulation and regulation legislation and harmonise prudential objectives, principles and methods across all categories of financial institutions and markets. 115 The market conduct aspect of regulation will make use of supervisory tools to reach its various aims. Traditional tools include on-site visits, reviewing reports, and issuing information requests. 116 New tools will include the testing of institution s customer services through mystery shoppers, sourcing information from third parties like the media and consumer bodies, and issuing and assessing consumer and industry surveys. 117 Another important power this 102 Ibid at Ibid at Ibid at Ibid at Ibid at Ibid at Ibid at Ibid at Ibid at Ibid at Ibid at

11 regulator will possess is to intervene to mitigate conduct risks at industry and institution level. 118 The approach used for market conduct regulations based on the fulfilment of its five mandates. The first mandate is to promote the fair treatment of financial service customers. 119 There are two main aspects of this mandate; the fair treatment of customers, and the enhanced effectiveness of the ombud system. 120 The regulator must assure the fair treatment of financial service consumers by enforcing the Treat Customers Fairly (TCF) approach. 121 The TCF approach has six outcomes which must be implemented: Customers must be confident when dealing with institutions and institutions must put customers first, products and services which are sold must be targeted properly, customers must be appropriately informed and given clear information, advice given to customers must be suitable to that particular customer, customers must be provided with products that perform the way institutions promised them they would, and customers must not face barriers related to product changes and making complaints. 122 The customer must also have access to effective dispute resolution which can give a fair outcome when other frameworks have failed. 123 The second mandate is to promote customers financial awareness and literacy. 124 This deals with improving a consumers bargaining power by making customers financially literate. 125 This will require efforts from government, schools, financial institutions. 126 The third mandate is to protect and enhance financial markets efficiency and integrity. 127 This requires the enforcement of securities regulation, managing collective investment schemes and secondary markets and the use of self-regulatory markets. 128 The fourth mandate is to contribute to the policy objective of financial stability. 129 The fifth and final mandate is to contribute to financial inclusion; this will ensure access to financial services to all South Africans. 130 South Africans need services which enable them to manage their money save for their futures and insure themselves and their valuables. South Africa clearly plans to use an intricate framework to ensure that regulation of the financial sector isn't just transparent but also consistent and concise. (b) implementation period for the Twin Peaks model Ibid at Ibid at Ibid at Ibid at

12 The Twin Peaks model has two phases. 131 The first phase has been implemented. 132 It was implemented in 2013 to It dealt with the development of regulatory legislation and the tabling of that legislation to parliament. 134 It also required resources and staff responsible for prudential regulation from the Financial Services Board to the Reserve Bank. 135 The second phase will be implemented over several years and will focus on creating harmony of the legislative, regulatory and supervisory systems and frameworks. 136 (c) enforcement of the Twin Peaks model The enforcement of the model is most important to avoid the recurrence of the crisis. There are various approaches to the enforcement of the Twin Peaks model. These will include administrative penalties, and criminal prosecution. Supervisors will also possess the power to suspend and withdraw licences and approvals, issuing orders to take or cease particular actions and debarments. 137 Certain contraventions currently in place will cease to be considered crimes instead there will be an institution of voluntary disclosure programmes, and judicial and administrative reviews. 138 Enforcement will be different between the prudential and market conduct regulator. 139 Each form of enforcement will depend on which is most effective for each one. Effective enforcement of the model will combine a number of appropriate approaches designed for specific cases. 140 The enforcement framework for prudential regulation will initially be based on existing legislation such as the Banks Act 141 and the Long-Term Insurance Act 142 but the prudential regulator will eventually include other enforcement tools in the framework. 143 The market conduct enforcement process will continue from the Financial Services Board Enforcement Committee. 144 It will adjudicate on contraventions and instances of noncompliance. 145 To promote compliance, the market conduct regulator will also run information campaigns about relevant issues. 146 The regulatory and supervisory response by South Africa seems well planned and can be implemented if all necessary bodies such as government, 131 Ibid at Ibid at Ibid at Banks Act 90 of Long-Term Insurance Act 52 of FRRSC Implementing a Twin Peaks Model of Financial Regulation in South Africa (2013) at

13 regulatory institutions and financial institutions play their role as set out in the policy document. VI. CONCLUSION It is evident that the financial crisis was the most devastating since the Great Depression. This catastrophic breakdown in the finance sector caused an international wave of unemployment and homelessness, especially in China and the USA but one important lesson was learnt during this crucial period. The financial crisis restructured the approach to regulation of financial markets permanently. The crisis showed the danger of lacking or overly stringent regulation or an inconsistency of regulatory rules. South Africa has seen the need for clear and concise rules and has responded by moving towards the Twin Peaks model. The Twin Peaks model allows a balance between financial stability and consumer protection objectives. This essay agrees that the implementation of the Twin Peaks model will insure that the effects of the financial crisis do not reoccur in South Africa. It concedes that the there might be a risk of overlapping and unnecessary duplication regarding regulators but this shortfall can be addressed through collaboration amongst the supervisors. The Twin Peaks model seems to be the most viable solution to avoiding another economic recession in South Africa.