Financial Innovation, Derivatives and the UK and US Interest Rate Swap Scandals: Drawing New Boundaries for the Regulation of Financial Innovation
| DOI | http://doi.org/10.1111/1758-5899.12300 |
| Date | 01 May 2016 |
| Published date | 01 May 2016 |
| Author | Vincenzo Bavoso |
Financial Innovation, Derivatives and the UK
and US Interest Rate Swap Scandals: Drawing
New Boundaries for the Regulation of Financial
Innovation
Vincenzo Bavoso
University of Manchester
Abstract
A number of questions remained unanswered with respect to the regulation of large financial institutions after the global
financial crisis (GFC) of 2007–08. Some pressing issues have resurfaced in the context of the recent interest rate swap scandals.
These events provided the opportunity to reflect on the wider socio-political agenda that involves the regulation of banks’
behaviour vis-
a-vis societal stakeholders. In particular, the Interest Rate Swap (IRS) scandals have shown the ability that banks
have to first, innovate and customise complex financial products, and second, limit their legal liability when selling them to
investors. This has resulted in a highly unfair balance of powers between financial institutions on the one hand and regulators
and financial consumers on the other.
Policy Implications
•The behaviour of banks should have regard for social priorities ahead of profit-making activities conducted in the interest
of banks’shareholders and executives.
•The desired behaviour of banks should be enshrined in statutory regulation.
•Regulatory changes should enhance the protection of financial consumers.
•The power of banks to innovate for speculative aims should be curtailed through more prescriptive regulation; this would
inter alia curb the problem of information asymmetry in financial markets.
•The balance of powers in financial markets should be reconfigured together with the role of financial institutions in
society.
1. Background
The years following the quasi-collapse of the global financial
system in 2008 have provided much evidence to contend
that the global financial crisis (GFC) is still ongoing. While
new regulation was being enacted in the US and in the EU,
a new generation of financial scandals was brewing, ready
to manifest in rapid sequence. From the Payment Protection
Insurance (PPI) mis-selling, through the Libor rigging manip-
ulation, to the Interest Rate Swap (IRS) mis-selling, the list is
certainly not exhaustive. Even though these events were
generated in the same ‘boom years’that preceded the 2008
crisis, they highlighted new features and exposed how dif-
ferent sections of society can be directly harmed by the
activities conducted by financial institutions.
This article focuses on the analysis of the IRS scandals that
exploded in the UK and in the US. The opportunity can be
taken for a broader reflection on the undesired effects of
financial innovation, particularly the ‘over-development’of
derivative products. Moreover, the scandals show the ability
that banks have to first, innovate and customise complex
financial products, and second, employ contractual terms that
limit their legal liability to investors.
Unlike previous scandals, the IRS events have directly
harmed different social stakeholders, outside the financial
services industry. The victims were individuals and small
and medium-sized businesses in the UK, and government
entities in the US. In both cases, complex derivatives were
sold by banks to investors who were not sufficiently aware
of the level of risk that they were taking.
By highlighting the flawed legal protection that is granted
to financial consumers entering into complex derivative con-
tracts (such as IRSs), this article poses two broader policy
questions involving financial institutions operating on a glo-
bal scale. First, it reflects on the role of financial institutions
in society, which entails a definition of the social function of
financial markets. Second, it looks at the power of banks to
innovate, which has made their relationship with both
[Correction added on 29 January 2016, after first online publication: The
Acknowledgement was previously omitted and has been added in the
author biography in this current version].
Global Policy (2016) 7:2 doi: 10.1111/1758-5899.12300 ©2016 University of Durham and John Wiley & Sons, Ltd.
Global Policy Volume 7 . Issue 2 . May 2016 227
Research Article
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