Legal system and financial market

Speech by Lorenzo Bini Smaghi, Member of the ECB Executive Board, on “Legal Issues Related to Financial Markets”, Opening Remarks at the Conference, Frankfurt am Main, 26 October 2007

ladies and gentlemen ^[1]:

We are very pleased to be organizing this conference on a topic that is of fundamental importance and, as I will explain later, even more interesting these days in view of the market turmoil.

The economics literature has emphasized that institutions in general and legal systems in particular are fundamental determinants of economic growth, particularly in relation to financial development. ^[2] By “legal system” we mean not only laws and rulebooks, but also the infrastructure of civil courts and market regulators.

In cross-country analyses, institutional quality and legal efficiency often overshadow other classical determinants of growth, such as the availability of national resources (rather than being a blessing in and of themselves). tends to be a curse) ^[3]), country size, physical capital, etc. This is a consideration that we, as economists, should probably take more seriously than we currently do.

The relationship between law and finance is inseparable. It is unthinkable to consider financial products without a financial system and the legal system that supports it. The keyword for economists in this context is “information asymmetry.” In particular, lenders do not know whether the borrower is trustworthy or whether the investment project the borrower is undertaking is worthwhile. Increasingly, financial assets end up being bills in the form of pieces of paper, or even account entries. In any credit relationship, and this includes almost any economic transaction that goes beyond a simple barter, the possibility of default is always looming, and precise measures are required to protect both creditor and debtor. Without a strong normative system, this inherent complexity cannot be resolved.

For creditors to consider entering into financial relationships, the legal system must not make it too easy for debtors to escape their obligations. At the same time, as Shakespeare's The Merchant of Venice reminds us, the legal system must not be too burdensome for debtors. Therefore, the legal system needs to evolve along the fine line between protecting the rights of borrowers and protecting the rights of lenders. It is no wonder that developing a sound legal system to support financial markets is a very complex issue, and we hope to learn something from today's conference.

Fundamentally, the legal system must ensure that contracts and property rights are sufficiently clear and predictable. In the event of a dispute, the participants to the contract will not feel the need to take legal action unless it is a last resort. Additionally, in the event of litigation, courts are independent and able to resolve claims effectively and within a reasonable time. Furthermore, a judgment must be carried out promptly after it has been handed down.

To emphasize the importance of this aspect, let me give an example from my country. There is a growing literature suggesting that one of the reasons for Italy's relatively slow pace of financial development is the slowness of its civil courts, with the result that mortgage debt, for example, remains a fraction of what is typical in other countries. remains. Developed country. ^[4]

At this point, it is clear that an efficient legal system is a key element of competitiveness among financial centers. One reason for the traditional lead of U.S. financial markets over Europe (and the rest of the world) is greater standardization of legal norms and institutions; It remains characterized by highly fragmented laws, regulations, and enforcement.

Without a proper legal system, it would be difficult to trade almost any financial product. Two different effects are possible. On the other hand, yields may rise and asset prices may fall as a result. In other words, asset yields may have a “legal risk premium” built into them. It is interesting to note that legal risk is part of operational risk under the Basel II system, which means that regulators take legal risk seriously. On the other hand, an inefficient legal system may simply cause firms to move elsewhere, thus affecting volumes rather than prices.

The importance of the legal environment was most prominently recognized in the January 2007 Bloomberg Schumer report, “New York and the United States Maintaining Global Financial Leadership,” which stated that “strong and predictable laws “The financial environment is the second most important criterion for determining financial position.” Center competitiveness. ”

Of course, an efficient legal system does not always mean more (and more restrictive) rules. A balance needs to be struck between restrictive rules and a lighter approach, and this can be important for the overall competitiveness of financial centres. Current debates about the competitiveness of the US market (particularly in relation to UK competitors) highlight that finding this balance is not always easy.

I would now like to turn to some issues related to the impact of financial globalization and innovation on the legal system. In my opinion, the protection of the rights of debtors and creditors becomes increasingly difficult with the development of financial markets, both in the geographical sense and in the range of available products (financial globalization and innovation). In fact, it becomes increasingly difficult. It is not difficult to understand the challenges posed by financial globalization. What legal system applies to a financial instrument issued in country A, traded in his country B by an intermediary headquartered in country C, and purchased by an investor resident in country D? . Will it be covered? How can nationals of country D enforce their rights? Which courts are responsible for disputes? What legal remedies are available to nationals of country A and her country B? . These are questions at the very heart of financial globalization. The simple observation that the vast majority of cross-border capital movements still takes place between developed countries suggests that such legal uncertainties (perhaps more important in emerging economies) may affect financial flows and financing around the world. It can be easily inferred that it plays a fundamental role in the allocation of capital.

Over the past few years, a number of initiatives dedicated to increasing legal certainty regarding such cross-border financial transactions have been carried out not only at European level but also at global level.International organization specializing in harmonization of laws [such as UNIDROIT or UNCITRAL] has shifted its focus to financial market issues, such as secure transactions and the holding and transfer of securities across borders. This focus is reflected by a number of complementary initiatives at European level. I would like to mention here the various legislative projects aimed at strengthening the integration of EU financial markets, which are also incorporated in the so-called Financial Services Action Plan. Recent attempts to strengthen the efficiency and integration of the EU post-trading industry include the clearing and settlement of cross-border securities transactions.

Looking at more recent events, the emergence of structured products, where creditors are separated from debtors by complex financial infrastructure that transforms and repackages the underlying assets, has the potential to create significant legal issues. Yes, and this can be an important concern. Regarding the recent market turmoil. If debtor A defaults and his debt is repackaged by bank B, sold to non-bank intermediary C, and finally sold to investor D, who will pay? It's a legitimate question and should be approached carefully. But to resolve the uncertainty surrounding the current environment, answers must be provided.

As you know, since the summer, a number of policy initiatives have been launched at the global level, such as by the Financial Stability Forum. ^[5] or by the unofficial ECOFIN in Porto ^[6] And it remains difficult to predict precisely the legal aspects that will be specifically considered by the various international and European forums and bodies involved in this debate. However, these efforts indicate that legal considerations may emerge, particularly in the European context.

Legal certainty must go hand in hand with transparency. The focus on complex financial products, transparency of institutions and instruments, and adequate disclosure of information regarding securitized debt and other structured financial products means that regulatory and supervisory authorities This indicates that the framework needs to be investigated in detail. We discuss securitization transactions and market standards, as well as how special purpose vehicles are currently regulated and supervised in various EU Member States and at the international level. European Financial Market Lawyers Group (EFMLG) May 2007 Report on Legal Obstacles to Cross-Border Securitization in the EU ^[7] Contains recommendations for further convergence of securitization law in the EU, allowing Member States to adopt certain principles common to all jurisdictions to ensure a high level of securitization law; Recommends the Commission to consider adopting EU Directives on certain legal aspects of securitization. Ensuring transparency, efficiency, and legal certainty regarding securitization transactions. ^[8]

Another issue that is often mentioned in connection with the current financial turmoil is the methodology adopted by rating agencies in the field of structured finance and the ability to assess in an appropriate manner the legal risks associated with the core of securitization transactions. The need to benefit from legal opinion. Identify the constituent elements and properly identify investor rights.

At this point, don't abuse your time any further. We hope that the message that we, as policymakers, are interested in ensuring that the global financial system has a strong legal foundation is effectively communicated. I wish you all the best as you contribute to this effort at this conference.

Thank you for your attention.