iBusiness, 2013, 5, 190-199
http://dx.doi.org/10.4236/ib.2013.53B039 Published Online September 2013 (http://www.scirp.org/journal/ib)
Institutional Economics, Risk Management, and
Breakdown of Corporate Social Responsibility:
Towards a New Architecture of Financial Markets
Hans-Georg Petersen, Alexander Martin Wiegelmann
Faculty of Economics and Social Science, University of Potsdam, Potsdam, Germany; Tax and Transfer Research Group, Berlin,
Germany.
Received 2013
ABSTRACT
The breakdown of the financial markets in fall 2007 and the following debt crisis in the EU have produced an enormous
mistrust in financial products and the monetary system. The paper describes the background of the crisis induced by
functional failures in risk management and the multifold principal agent problems existing in the financial market
structures. The innovated nontransparent financial products especially by the so-called shadow banks have mixed up
differential risk weights and puzzled or even fooled formerly loyal customers. Contemporaneously abundant liquidity
on the international financial market accompanied by easy money policies of the Fed in the US and the ECB in the euro
zone have depressed the real interest rate to zero or even negative values. Desperate investors are seeking for safe-assets
but their demand remains unsatisfied. Low real interest rates and the consequently lacking compound interest effect in
the same time jeopardize private as well as public insurance schemes being dependent on capital funding: the demo-
graphic crisis becomes gloomy. Therefore, the managers of the financial markets have to reestablish CSR and to sepa-
rate the markets into safe-asset areas for the usual clients and “casino” areas for those who like to play with high risks.
Only with transparency and risk adequ ate financial products the lost commitment can be rega ined.
Keywords: Capital Funding; Corporate Social Respon sibility; Financial Markets; Principal Agent Problems; Risk
Management
1. Introduction
In complex, democratically steered market societies be-
side the citizen, who are the principals in the political as
well as economic spheres, the corporate and the govern-
ment sectors have to serve the individual interests of the
citizen. The managers in the private corporations as well
as banks and the public institutions are the agents, being
controlled via competition on more or less efficient mar-
kets or the voting mechanisms in the political setting.
From both sectors the principals need the best informa-
tion to evaluate the quality of the agent’s performance
and to control their actions. Principal-agent-problems
(PAP) arise, which jeopardize the welfare development
in the whole society if information is asymmetric in fav or
of the agents and the control intensity of the principals is
not sufficient. Agents start to hide risk and misinform the
principals, decision making regarding investment of eq-
uity capital and involvement in public affairs becomes
highly difficult [1]. Hence, institutional arrangements
(regulations) to assu re transparency on the economic and
political markets are of utmost relevance to prevent the
agents from exploitation strategies, which are played
against the principals.
Without doubt the monetary sector plays an important
role for the growth processes in emerging as well as
highly developed co untries. In real life always the risk is
involved that the power of one sector might become
dominating and even endanger the future development of
a well-balanced societal system. The modern monetary
system is a fundamental invention of mankind. The wel-
fare of a society is created in the productive sectors, e.g.
the primary (agricultural) and the secondary (industrial)
sector. With increasing labor division and specialization
the complexity of a society is strongly increasing so that
a highly developed monetary sector (as important part of
the tertiary sector) is a basic prerequisite to improve the
growth potential of a society. The implementation of a
monetary system dramatically reduces the transaction
costs of a barter economy and works almost as a “lubri-
cant” for the further development process. There is no
doubt about: the finan cial sector has contributed substan-

Institutional Economics, Risk Management, and Breakdown of Corporate Social Responsibility:
Towards a New Architecture of Financial Markets 191
tially to the welfare gains in highly developed societies.
It serves as intermediary in between the lenders (savers)
and borrowers (investors) and has to manage the credit
risks at maximum risk transparency for all market par-
ticipants and the public.
But as usual – there is a reverse side of the coin: A
monetary system has to play a supportive role for the
economic process because the welfare is predominantly
created by the primary and secondary sectors. While in
the primary and secondary sector equity capital of the
business owner (sole trader or shareholder) is dominating,
the financial sector is much more dependent on deposits
and borrowed funds: the Basel II Accord demands an
equity capital (mini mum capital requirement) to secure a
banks solvency, which has to be in between 1.6 and 12.5
% depending on the individual risks structure. Further-
more bank capital is difficult to define and high ly volatile.
Since banks are predominantly working with borrowed
capital, issues are involved, which have been described
by modern institutional economics: the principal-agent-
problem and moral hazard. Hence, state (and interna-
tional) regulations for the financial sector (banking and
insurance system) are necessary to protect the investors
and capital owners (principals) against exploitation by the
managers of the financial sector (agents), which in reality
often show moral hazard behavior in taking too much
risks for the borrowed capital. If efficient regulations are
badly missing, fraud and corruption destroy fairness and
justice leading to mistrust in governance in the private
and public sector, respectively.
2. Financial Architecture in Transition
The political changes in Europe in the late 80ties of the
last century have led to a process of liberalization and
globalization of the financial markets without sufficient
adaptations regarding the traditional macro-steering of
the monetary policy as well as the regulations for the
banking and insurance markets. Therefore, beside the
conventional banks (like commercial banks in the Euro-
pean tradition) a so-called shadow banking sector
emerged, which at least temporarily has dominated the
private sector lending. Even in emerging markets like in
China, in which the strongly regulated and restricted
banking system bears a resemblance to the currency the-
ory,1 where central bank money is allowed as only legal
payment instrument, a considerable shadow financial
sector arose. This growth took place in the “shadow of
the traditional state regulations” and even in the Basel
Accords many shortcomings were involved, so that all
ingredients were mixed up for a super crash on the liber-
alized international financial markets.
2.1. Traditional Banking and Insurance System
The European style of the monetary system is a system in
which in accordance with the banking theory the com-
mercial banks are allowed to create credits on the basis
of the central ba nk deposits. Traditional monetary policy
instruments (like the minimum reserve policy) determine
the so-called credit creation multiplier; central bank
money (M0), bank money and other near money assets
(money at call, time deposits etc.) are forming the money
supply in an economy (M1, M2, M3). The returns on
credits have to cover the bank costs and potentially gen-
erate profits while at the same time safeguarding the
bank depositors via accumulating sufficient equity capi-
tal as risk buffer for unexpected liability cases (con-
nected with consumers protection). Beside the central
bank based credit creation commercial banks could also
take credits from private clients, capital markets or other
banks (interbank transactions), which also has to be frac-
tionally assured by underlying equity capital, so that in
addition to the credit creation multiplier an additional
leverage effect has been implemented. The commercial
banks have to safeguard that the maturity and/or liquidity
patterns of the lent and borrowed money coincide, not to
get illiquid and to run into insolvency. As important as
the matching of these patterns is the correct evaluation of
the credit risk.2 If credit defaults occur, at first the equity
capital of the bank is liable so that th e capital base of the
bank is weakened, being another reason for possible bank
insolvency.
The credit risks are directly checked by the credit cre-
ating banks themselves (house bank system, which is
nontransparent for outsiders) or more recently more often
indirectly by CRA, where the rating results are public but
the evaluation methods only known by the respective
rating agency and consequently also nontransparent for
outsiders. Limited or even false information creates
asymmetries in favor of the agents (bank managers, asset
managers, CEOs of the rating agencies etc.) regarding
credit risks, which might be exploited by higher remu-
neration and bonuses.
2Until the implementation of the international accounting standards
(IAS, IFRS etc.) the traditional German setting in accounting and bal-
ancing adheredthe lowest value principle to protect the depositors and
consumers. In banking this principle very strictly limited the credit
creation possibilities so that it was substituted by the Anglo-Saxon true
(or fair) value concept. The true value is a value deemed accurate and
reasonable by the person who prepared a statement. Compared to the
lowest value, usually the fair value is considerably higher and conse-
quently bears a much higher risk of error. Therefore, fair value evalua-
tion is a more subjective value and part of risk management, which has
to be controlled by external agents (like banking su pervision or CRA).
1For details see [2]. Most modern banking systems are following the
banking theory [3].

Institutional Economics, Risk Management, and Breakdown of Corporate Social Responsibility:
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192
The insurance system is closely linked to the banking
system because of a partly similar role in the economy.
Insurances are also managing risks (biometric and real
asset risks), which necessitates the protection of the cli-
ents premiums (deposits) via capital funding. The in-
vestment of the capital funds has been usually organized
with assistance of the commercial banks, temporarily
following the one-stop finance concept.3 Hence, the in-
surances are the most important institutional investors
and the largest lenders in the credit transformation proc-
esses. Because of the interlinking with the banking sys-
tem, insurances are usually more or less directly infected
by problems generated in the banking system. Addition-
ally insurances are influenced by monetary policies,
which have direct impacts on the real interest rate of their
assets. Especially the performance of life insurances is
heavily dependent on the long-termed compound interest
effect, which might mitigate the consequences of demo-
graphic change in the highly developed countries. In case
of low or even n egative real interest rates, low returns on
equity of even losses would reduce the important com-
pound interest effect, impair the insurability of biometric
risks and capital funding as alternative to the today’s
dominating pay-as-you-go systems and make the future
perspectives even more gloomy [5].
The problems of the traditional banking and insurance
schemes are to be seen in several reasons; the first im-
portant one was overemphasizing the deposit protection
(“investment grade obsession”) in the interests of the
bank clients (consumer’s protection) in the last decades
of the last century. The second important problem was
created by over-stressing public interventions to assure
price- and systems-stability, likewise to guarantee the
security of the whole money supply system. Thirdly, the
credit creation took place only on the basis of specific
collaterals being predominantly real assets (like mortgages
and pawns, the so-called asset-based-lending where the
credits remained in the credit creating bank and were not
traded).4 Only in exceptional cases nonmaterial values
(goodwill of a company, individual credit-wo rthiness, so-
called relationship or projected-cash-flow-lending) have
been taken as bank securities, being much higher risky as
real assets, which in case of misevaluation occasionally
led to bankruptcy of single banks (the typical house
banks). Last but not least public guaranteed bank depos-
its and public deb t titles hav e been generally pr esu med as
trustee stocks (dominating as assets in the insurance
schemes) and as a perfect substitute for central bank
money.5
However, the credit creation potential of such a tradi-
tional banking and insurance system turned out to be too
restrictive for creating a sufficient credit supply for the
borrowers and a fair return on investment for the lender.
The credit crunch in some decades of the last century has
obstructed growth and development – the keywords were
capital shortage for risk capital and under-financing of
small and medium enterprises (SME). The limited ability
of the traditional system to create necessary credit vol-
umes was accompanied by an excess supply of liquidity
on the international financial markets, originating from
the dramatically increasing rate of return on raw materi-
als (especially energy products) as consequence of the
1990 change and the increased central bank money sup-
ply in the US owing to overcome the crisis of the dot.
com-bubble in 2000 and 9/11 in 2001.
2.2. Evolution of the Market Based Credit
Transformation
Financial innovations at the end of the last century have
been the most important prerequisite to overcome credit
crunch and growth retardation. The invention of new
financial institutions and products has been the outcome
of the process of liberalization and globalization in the
following two decades. Already in the Thatcher era in the
United Kingdom and the Clinton administration in the
United States it has become obvious that public debt ti-
tles were losing in relevance and new financial market
segments had to be developed to meet the increasing de-
mands for attractive financial products. The branch of the
investment banks was strongly growing, in the first phase
dealing predominantly with securitizing receivables of
larger enterprises thereby inventing collateralized debt
obligations (CDO). Parallel to that process the invest-
ment banks introduced the securitization of mortgages
creating the collateralized mortgage obligations (CMO),
which in the further course of the development have
paved the way for the subprime mortgage crash (see be-
low).
In the following periods a highly complex system of
new institutions and financial p roducts has been inven ted.
Conventional or commercial banking was supplemented
by a “shadow banking system” (non-deposit banks like
hedge funds, structured investment vehicles, investment
banks, private equity funds, money market funds, insur-
ers etc.). These “shadow banks” do not have a banking
license and the allowance to create banking money by the
3Presently the involvement of insurances in the banking based credit
transformation has been reduced because insurances are more engaged
in the market based credit transformation [4].
4These first problems might be also true for China, because here credit
ratios and capital controls are implemented.
5In the Basel Accords the minimum capital requirement for public debt
securities from OECD countries has been zero independently from the
factual risk situation of the borr owing country.

Institutional Economics, Risk Management, and Breakdown of Corporate Social Responsibility:
Towards a New Architecture of Financial Markets 193
credit creation multiplier. They only are based on the
equity capital of their owners, which is borrowed to ex-
ternal clients. But via the debt service returns and the
possibility to securitize their credit titles (substitution of
bank credits by tradable securities, e.g., ABS), the credit
leverage of that banks has been extended and an addi-
tional leverage effect was invented, which has also mul-
tiplied the possible credit volumes.6 This vehicle is also
used by commercial banks. Beyond that leverage effect
the invention of bad debt insurances has created another
leverage impact: For higher risky collateral the risk
component of such an asset is separated from the stock
and transferred via credit default swaps (CDS) to debt
insurances, which relief regulated banks from risk buffer
constraints also increasing the credit volume. As long as
the risk evaluation is done by reliable risk managers and
controlled by efficient and independent CRA, such a high
leverage system might function. If the agents (risk and
asset managers) are behaving in the sense of PAP and
moral hazard,7 such a system degenerates to a pure Ponzi
game.8 Then the limits from adequate risk management
to fraud and criminal actions are clearly surpassed.
No wonder that the credit volume of the shadow
banking system was permanently increasing and outpac-
ing the credit volume of the commercial banks ( Figure
1). If then the commercial banks are trying to catch up in
buying such contaminated assets (“junk bonds”) or even
starting similar credit procedures, the commercial bank-
ing system and the insurance system itself become in-
fected, too.
The real shortcoming and threat for the existence of a
sound financial system was the fact that the shadow
banking system was not sufficiently under control and
supervision. Regulatory and supervisory measures of
respective jurisdictions did not sufficiently account for
all these changes; neither did supranational rules such as
the Basel Accords (Basel I and II). The financial innova-
tions as well as the new financial institutions were per-
manently becoming more and more complex so that the
information on the real risk structures of the different
investment products became increasingly opaque. This
was especially true for the multiple securitization struc-
tures, where even experts were not able to evaluate the
product quality.
This innovation process was accompanied by a grow-
ing relevance of the CRA, which became the external
evaluators for the credit creation processes in the com-
mercial as well as shadow banking area. At the beginning
the ratings have been limited to CDO’s of large corpora-
tions but step by step the CRA have won influence even
in evaluating public debt titles.9 The fact that CRA have
been paid by the own clients (corporations and jurisdic-
tions being rated themselves) and have been personally
closely linked by staff exchanges with the banks supply-
ing the credit titles under consideration have impaired the
objective evaluation processes so that serious evaluation
failures or even corruption and fraud might have been
involved in many cases. This has been demonstrated by
the false evaluation of the rating agencies (Standard &
Poors’s, Moody’s, Fitch Rating), interestingly being all
US private companies. Obviously there has been no
product liability for financial products – neither on the
national and nor on the international level – while the
product liability for ind ustrial products is hig hly stringent
even on an international basis.
Consequently a flood of new financial products was
invented to attract the excess supply of capital: asset
backed securities (ABS), the already mentioned CDO
and CMO, collateralized loan obligations (CLO), collat-
eralized bond oblig ations (CBO), co llateralized insurance
obligations (CIO), credit linked notes (CLN), credit de-
fault swaps (CDS), other types of true-sale and synthetic
securitizations of different forms of debt, derivatives and
future markets, secondary markets for re- or multiple
securitizations).
Experienced bankers and even highly professional as-
set managers were sometimes overburdened in correctly
assessing the new products especially regarding the
complex risk structures.
Without doubt the evolution of the so-called marked
based credit transformation has substantially increased
the credit volumes in the national economies and solved
the problem of the credit crunch of the last decades be-
fore the process of liberalization and globalization. But
as typical in economics everything is connected with
opportunity costs, which in this case have especially been
complexity and risk non-transparency. As already men-
tioned before national and supra-national (Basel Accords)
regulations continued for the traditional commercial
banks and insurances; principally necessary adaptations
for the emerging shadow banking system remained un-
done, the marked based credit transformation was left to
one’s own devices. As consequence of the lacking regu-
6Because of the strongly increasing credit volumes the US Fed in 2006
stopped to report the further development of M3 just in a period where
a substantial increase of M3 was observed. In macro-prudential view a
traditional measure of monetary expansion was badly missing, which
had impaired the critical analysis of the systems impacts of credit
transfer instruments in the US [4].
7That does mean that both groups of persons involved in that process
are maximizing their personal incomes in the shortest possible time,
thus possibly causing a crash of t he w hol e fi nanc ial system.
8The most prominent example is the subprime debt market, where
refinancing occurred through increasingly opaque financial structures
until the realization of value depreciations caused the entire system to
collapse. 9For details on the problems with CRA see [6].

Institutional Economics, Risk Management, and Breakdown of Corporate Social Responsibility:
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194
lations the financial intermediaries (provider of financial
products) and CRA were exclusively following their own
interests (profit and remuneration maximization), the
financial sector gained dominance over the real economic
sector.
The involved bankers and asset managers obviously
were not following the often propagated guidelines of
corporate social responsibility (CSR) [7]; they have not
acted as decent tradesmen (“ehrbare Kaufleute”), which
in the German literature is the basis for the concept of
CSR [8]. Dubious financial products flooded the market
based credit transformation (Figure 1) and overdrew the
credit volume in maximizing the leverage effect and
minimizing the equity capital reserves. Investors and con-
sumer’s as well as depositor’s protection beside the pub-
lic deposit guarantees were almost totally neglected. All
problems discussed in the theory of new institutional
economics emerged, just to mention PAPs, moral hazard
and the collapse of all ethical gu idelines – in view of the
public the “honest banker” mutated into the “bangster”,
which is the combination of banker and gangster.
Especially in the USA a shadow banking system
emerged, which tremendously gained in relevance and
even started to dominate the classical banking structures
(Figure 1).10 In such an environment “subprime mort-
gages” (in reality an irresponsible Ponzi game) could be
“invented”, which have almost destroyed the monetary
system in the 2008 crisis. The exaggerated risk behavior
of the US shadow banks, which in the first in- stance
have created high profits, has also infected the behavior
of the European banks (especially of the Deutsche Bank,
which US establishments played a very questionable and
devastating r ole11).
In a short term perspective even very dubious profits
made by debt financing and extreme risk taking increase
the rate of return, which induces rising market capitalize-
tion at the stock markets. If conventional banks are not
following, they are losing in market capitalization and
are endangered by an unfriendly takeover. Therefore,
more and more banks had to take increasing risks posi-
tions for the survival in a strongly increasing footrace for
a better competitive position – finally leading into the
almost collapse of the financial system.
The widening of the financial markets has increased
the pressures on the commercial banks and insurances to
move into business segments, which formerly were in the
hands of specialized financial institutions (like investment
banks, private equity funds, hedge funds, etc.). Even
German banks with high reputation temporarily have lost
the interest in their smaller private client segment and
concentrated on big firms and investment banking. The
short-termed windfall gains indu ced a pr ocess of mer ge rs,
which has substantially increased the concentration being
a threat for future competition. Similar processes have
taken place all over the world so that only few and big
banks remained, which are called “systemic” banks, be-
ing too big to fail, because their bankruptcy would now
endanger the existence of the national or supranational
financial system, or to connected to fail, because their
bankruptcy would endanger the all the other institutions
in the ABS production chain. All this has been accompa-
nied by more or less inefficient CRA being private firms,
which are not at all adequa tely regulated – by neither the
national states nor international organizations. This has
led to the outcome that an increasing number of experts
and citizen has lost confidence in financial institutions
despite of the fact that financial products are predomi-
nantly “credence goods”.
3. Empirical Pictures of the Crisis
The international financial markets have been character-
ized by a high and increasing liquidity in last decades,
especially after the liberalization as consequence of the
fall of the iron curtain. Additionally the periods of con-
solidation in the budgets of the US and the UK men-
tioned above have induced innovations in the financial
markets, which have strengthened the leverage effects
and enlarged the credit potentials. Increasingly risky fi-
nancial products accompanied by the introduction of the
new currency in Europe (euro) have led into the financial
crisis, in which the exploding public debt in the euro
zone has contributed additional risks for a gloomy per-
spective.
3.1. Financial Innovations and High Yielding
Bonds in the US
As mentioned before especially the increasing resource
rents in the primary materials producing countries have
flooded the international financial markets since the be-
ginning of the 1990ties, which had just been almost to-
tally liberated after the 1990 change. Additionally a long
period of strong economic growth was observed in the
emerging BRICS (Brazil, Russia, India, China, and South
Africa) nations. The raw material producing and emerg-
ing countries were not able to absorb all the export sur-
pluses in their own countries so that especially their gov-
ernments and/or banks were looking for profitable in-
vestments especially in the high developed industrial
nations. The alternative investment in the really needy
developing countries (often being “fragile states” [9]) did
not take place because of the supposedly lacking “in-
10In chart 1 ABS means asset backed securities and CDO collateralized
debt obligations.
11See the unmasking article in Der Spiegel, No. 5, 30.01.2012: “Die
Zocker AG – Die dubiosen Geschäfte der Deutsche n Ba nk ”.

Institutional Economics, Risk Management, and Breakdown of Corporate Social Responsibility:
Towards a New Architecture of Financial Markets 195
vestment security” so that their growth remained com-
paratively moderate. The excess of saving over desired
investment in the past two decades has been absorbed in
the highly developed countries – the US and the member
states of the European Union. Here the investment took
place predominantly in the new financial products and
government bonds. The excess liquidity and the policy of
cheap money in the US and Europe has set the question-
able incentive to reduce savings in the high developed
countries and to increase their foreign debt [10].
The empirical development in the USA, which has
generated the financial crisis of 2007/08, is shown in the
following Figures 1 and 2. Figure 1 demonstrates that
since 1985 the relevance of the shadow banking system
(supplying the “financial innovations”) was permanently
increasing. The growth of the market based credit trans-
formation by the largely unregulated ABS issuers out-
paced the growth of regulated conventional bank prod-
ucts; in 2008 the volume of the shadow banking sector
reached its peak with about USD 20 billion compared to
the conventional banking sector with about USD 11 bil-
lion.
The so-called true-sale securitizations are divided into
the conventional ABS and collateralized debt obligations
(CDO). Conventional ABSs consist of broadly diversi-
fied and homogenous receivables; its credit worthiness
can usually be estimated by actuarial mathematics.
However, CDO is an umbrella term for structured debt,
collateralized by much more heterogeneous assets like
credits of private companies partly traded on the stock
exchange, illiquid property, real estate credits (CMO),
payment requests for automobile loans, credit cards loans,
student loans, consumer credits, public debt titles etc.
Additionally CDOs themselves have been securitized
again (re- or even multiple-securitization) so that for the
customers the risk structures usually were totally hidden.
Figure 2 represents the breakdown of true-value secure-
tizations in the US and its development since 1985. The
figure illustrates that the subprime mortgages have per-
manently won in relevance and the same is true for the
CDOs. However, especially highly complex and risky
products have dominated the markets for true-sale-secu-
ritizations.
Hence, an efficient individual risk management was
not any longer possible. At least the higher yield for
some of the products was a rough hint that the involved
risks were steadily increasing. And all that has happened
without any information and warnings for the involved
customers. Liability and responsibility considerations
have obviously not taken place on side of the product
innovators and any product recall – as it is usual for de-
fective products in the industrial and consumption goods
sectors – has never happened.
1 ABS issuers include conduits such as special purpose vehicles.
Source: [4].
Figure 1. Growth of the Securities Emissions in the US-
Financial Sectors.
2 Especially CDOs. Source: [4].
Figure 2. Breakdown of the US-True-Sale-Securitizations.
3.2. Euro Implementation, Crisis of Credits and
Exploding Public Debt
Parallel to that period of product innovations on the fi-
nancial markets and the US policy of cheap money to
overcome the explosion of the dot-com bubble in 2000
(collapse of the “New Market”) and 9/11 in 2001, the
implementation of the European currency zone took
place. The policy of cheap money was reflected in the
development of the US federal funds rate: Since the be-
ginning of the 1980ties this rate was strongly decreasing
(also reflecting the declining inflation rates) and reached
in the crisis years 2007/08 and following almost zero
percent [10]. The crisis of credits arose in several steps:
- The aggressive subprime mortgage policy of the US
shadow banking system (including European subsidiary
companies, e.g. of Deutsche Bank and many German
“Landesbanken”) has led to lower lending standards and
high-risk mortgage products (like adjustable rate mort-
gages).
- Regulatory incentives – especially through the
Basel Accords – favoring not only OECD public and
bank debt but also home mortgages, fueled the credit
allocation bias of re gul ar banks.
- The limitation of mortgage liability on housing in

Institutional Economics, Risk Management, and Breakdown of Corporate Social Responsibility:
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196
the US; there is no jointly and severally liability for ind i-
viduals like in many European countries.12
- Malfunctioning of CRA in overlooking the massive
problems especially in the shadow banking sy st em.
- The real estate bubble (Ponzi or pyramid scheme) as
consequence of careless or even irresponsible policies
and investment behavior.
- Breakdown of the overheated real estate markets in
the US and Europe as well as the collapse of some shadow
(investment) banks.
- Infection of commercial banks and insurances,
which have bought junk bonds (especially CDOs).
- Overreaction of the CRA in down-grading the gov-
ernment debt titles in the US and Europe.
- Real collapse of economic activities in single coun-
tries accompanied by significant monetary and fiscal
policy reactions.
- Decreasing GDP and increasing interest payments
on government debt indu ced enormous budget deficits.
- The enormous increase in refunding needs in some
EU member states caused even stronger rising interest
rates.
- Single countries came close to bankruptcy (GIIPSC
– Greece, Ireland, Italy, Portugal, Spain, and Cyprus).
- Crisis of confidence into the euro system.
- Implementation of financial rescue-parachutes.
Having the development in the euro zone in mind, the
implementation of the euro, especially the convergence
process before the implementation phase, has reduced the
inflation and improved the stability situation in most of
the participating member states of the EU. Figure 3
demonstrates that the introduction process of the euro has
had an enormous impact on the interest rates in the coun-
tries of the euro zone; as an example the net yield of the
10 years government bonds has been chosen. It becomes
obvious that the euro implementation has dramatically
reduced the interest payments on government bonds es-
pecially in the GIIPSC states. In the year of the introduc-
tion of the cash euro 2002 the interest rates of almost all
member states of the zone came down to the German
level. And the spread in between the interest rates re-
mained very close until the beginning of the crisis in the
first half of 2007.
Therefore, the implementation of the euro has led to a
strong decrease of the interest structures in all the mem-
ber countries with the exception of Germany, which has
already faced before very moderate interest rates due to
the stringent monetary policy of the Deutsche Bundes-
bank. This decline in n ational interest payments has worked
like an economic stimulus package, which caused a
boom period at least in some member countries, whereas
Germany remained in stagnation until competitiveness
was recaptured by business restructuring and the meas-
ures of the Agenda 2010 (reforms in the social security
system).
The low interest rates have not only influenced the
economic activities in the member countries but also
induced the governments to increase their public debt via
the extremely liquid international financial markets. The
foreign debt dramatically increased, which at least for
some period was hidden because of the remaining mod-
erate interest payments in the public budgets. But if the
public debt exceeds a level of in between 60 and 80 per-
cent to GDP, increasing interest rates usually cause a
dramatic hike in the interest payments so that exploding
budget deficits came to the surface. Hence, these devel-
opments induced an increased heterogeneity in the euro
zone and the EU. A process of divergence within the
economic indicators, especially the internal inflation
rates and deficits in foreign trade, came into existence.
Since 2007/08 these processes have step by step and
much too slow ly been interna lized by CRA, which abruptl y
changed their policies and simultaneously caused a sudden
collapse of trust in the governments abilities to manage
such a crisis. The reflection on the intern ational financial
markets was an explosion of the risk component in the
compound interest rates, which also happened in the euro
zone and is depicted in Figure 3, too.
The citizen in the GIIPSC countries increased even
more the consumption levels, bought goods and services
in the few stable countries in the euro zone (Finland,
Germany, Luxembourg, and the Netherlands) and a real
exodus of capital from the GIIPSC states to the stable
Northern member states of the euro zone happened,
which is clearly expressed in the so-called target2 bal-
ances of the European Central Bank (ECB), reflecting the
Source: Wikimedia Comm on s,
http://commons.wikimedia.org/wiki/File:Long-term_interest_rates_(eurozon
e)_(1993-2011)de.png
Figure 3. Net Yield of 10 Years Government Bonds in Some
Member States of the Euro Zone.
12The slogan is: Drop of your keys at the bank and get rid of the liabil-
ity!

Institutional Economics, Risk Management, and Breakdown of Corporate Social Responsibility:
Towards a New Architecture of Financial Markets 197
imbalances in the balances of services and capital move-
ments of the single member states.13 Figure 4 represents
that since summer 2007 the formerly negligible target2
balances have almost exploded and reached their peak
level in July/August 2012. Since then the maximum gap
especially in between Germany and Spain but also in
comparison to the other member states of the euro zone
is slightly diminishing.
The slightly reversal trend in the target2 balances since
fall 2012 is also reflected in the development of the gov-
ernments bonds net yield. The implementation of the
European financial rescue-parachutes (Security Market
Program SMP of the ECB, European Fiscal Stability Fa-
cility EFSF, European Stability Mechanism ESM, Euro-
pean Fiscal Compact EFC, European Financial Stabilisa-
tion Mechanism EFSM) as well as the implicit guaran-
tees communicated by the ECB have obviously tempo-
rarily calmed down the actors at the international finan-
cial markets so that the long-term interest rates have –
with some interruptions – also fallen since fall 2012.
The future will show if the political measures having
been implemented will be sufficient or not. On ly an eco-
nomic policy within the single member countries which
will reduce the public deficits and the interest burden in
the budgets seems to be feasible for consolidation and
gaining back the trust into the national governments. All
the discussions on growth enhancements up to now have
been pure rhetoric because nobody has been able to ex-
plain how such programs can be financed without en-
dangering the future again – despite of the fact that such
concrete programs are badly missing.
4. Elements of a New (European) Financial
Architecture
The perception of the financial crisis in the affected
countries heavily depends on their different interests.
Countries with a strong industrial sector are much more
interested in a stringent regulation of the financial mar-
kets than countries with dominating financial sectors.
Therefore, the US and UK are advocating much more
liberal regulation than many other European Union
member states. And up to now the US have been able to
disguise its own debt crisis behind an extremely expan-
sive monetary policy and by accusing the euro zone (es-
pecially Germany) for insufficient actions against the
euro crisis. Because it seems to be very unlik ely that bo th
countries, the US and UK, will change their behavioral
patterns in the near future, the other EU member states
are pressed to get emancipated from the overseas de-
pendencies in developing an own financial architecture
and to start with systems competition against the (neo)
liberal model.
The problems of the past (ex post elements) can only
be solved by (1) involving the financial markets in fi-
nancing the welfare losses of the crisis via a financial
transactions tax (FTT). (2) The owners of the shadow
banks have to contribute to the crisis costs and then the
lenders dependent on their professionalism (at first
large-scale investors, then smaller-scale investors). (3)
The taxpayers have to function as lenders of the last re-
sort and not generally tak en into liability (only in case of
real “systemic” problems).
Protective elements are (1) the clear separation of fi-
nancial markets in “save harbors” for small-scale invest-
tors and institutional investors (like insurances and pen-
sion funds) and risk markets in the sense of Sinn’s “ca-
sino capitalism” [12], (2) the introduction of quality
standards and quality assurance of financial products to
safeguard the small-scale investors, and (3) the introduc-
tion of liability norms inclusive recall of defective prod-
ucts (like in industry) differentiated for the different risk
classes.
Preemptive elements are: (1) Micro-prudential regula-
tion regarding the CEOs and asset managers, which
stresses the sustainable management of financial markets
by strengthening the regulatory incentives for compre-
hensible and controllable self-monitoring mechanisms
(because CSR is not a pu re marketing strategy but an im-
portant concern of the employees in the financial markets:
“not to bite the hand that feeds you”). (2) Macro-pru-
dential regulation via central banks and financial super-
visory bodies by incorporating all financial intermediary-
ies with exactly adapted regulation elements and a mone-
tary policy strategy to safeguard an appropriate real in-
terest rate in the long-termed development. (3) Micro-
and macro-prudential regulation has to assure risk trans-
parency and general security for small-scale and institu-
tional investors to regain confidence and goodwill into
the banking and insurance system, setting the right in-
centives for further savings and investments.
Source: Euro Crisis Monitor, Institute of Empirical Economic Research,
Osnabrueck University, http://www.eurocrisismonitor.com/index.htm.
13For more details on the target2 balance s s e e [ 1 1]. Figure 4. TARGET2 Balances of the ECB (billion euro).

Institutional Economics, Risk Management, and Breakdown of Corporate Social Responsibility:
Towards a New Architecture of Financial Markets
198
In case that all these elements alone should not change
the regional development patterns it should be made to-
tally clear that a separation of commercial and invest-
ment banking would be the consequence, including tem-
porarily capital transactions co ntrols for countries, which
do not take part in substantial reforms of the financial
sector. These extreme solutions are just mentioned to
prevent outsiders from any illusions regarding the will
and capabilities to introduce such a new financial archi-
tecture. It is much more likely that such a regional solu-
tion in the euro zone or the EU (with or without the UK)
would lead to a secure “investment harbor”, which for
sure will attract the international investors if a sufficient
real interest rate is guaranteed. Hence, the competition
against the neoliberal “casino” model can be won.
Some of the proposed elements might also be of value
for the further development in the Chinese financial sys-
tem, which as mentioned above is much more restricted
because it bears a resemblance to the currency theory.
This theory holds especially true as not only the credit
creation, but also inter-bank as well as cross border capi-
tal flows are controlled by the Chinese government and
subject to quotas, see Figure 5. Nevertheless, a shadowy
side is introduced to this system caused by incentive
based credit allocation distortions, restrictive monetary
policy and informati on asymmetries regardi ng credit risks.
For compensating the lack of investments into private
companies and projects also in China an uncontrolled
credit market (shadow banking) emerged. According to
Credit Suisse estimates, shadow banking in China repre-
sents “25% of total outstanding credit and half of new
credit issued last year” [13]. Lending through the Shadow
Banking channel is either conducted via brokered “in-
vestment vehicles/trusts” or via three different shadow
banking institutions.14 The former are mostly designed
and sold through regular banks and their less controlled
wealth management divisions, which also sell other
wealth management products. Hence, savers are being
diverted from guaranteed bank deposits, earning negative
real interest rates into speculative investments yielding
higher returns [14]. The latter are conducted in unregulated
peer-to-peer relationsh ips by “small lender s”, “pawn shops”
and “guarantors” [15]. Both types of shadow Banking in-
clude non-standardized and nontransparent lending pro-
cedures, therefore, building information asymmetries
regarding credit risks. This system obviously also de-
mands a new architecture, which is beyond the scope of
this paper.
5. Conclusions
The lessons to be learned learn from the last financial
Figure 5. Overview on Chinese Regular and Shadow Bank-
ing Sectors.
crises are multifold. The financial sector as part of the
service sector has developed too strong self-interests ex-
pressed in extraordinary rate of returns, salaries and bo-
nuses – the self-interests of the agents have dominated
the ownership-interests of the principals. Therefore, the
role of the financial sector has become more and more
relevant, almost displacing not only the owners interest
but also the political influence. The financial sector has
to be reduced to its classical role in serving the real
economy under the regulation of strong national states
and international organizations. The agents in the finan-
cial sector have to be reminded to a personally binding
code of conduct so that the peoples’ trust in financial
institutions is safeguarded and not sacrificed for short-
term personal advantages.
The concentration process within the financial sector
has to be stopped by adequate regulation to secure a suf-
ficient degree of competition in between the different
institutions of the banking and insurance sector. The ori-
entation only in the direction of the big clients (large
enterprises or rich individuals) has to be corrected in fa-
vor of a banking and insurance scheme, in which the av-
erage citizen is in the focus of financial services. A com-
bination of saving banks, cooperative banks and private
banks is of utmost relevance. The old German “house
bank” system has been a good example. Private clients
and firms have organized their debit and credit relations
using such a single bank and the bank managers were
perfectly informed about their credit risks being inde-
pendent from other agents (like the CRA). The Basel
Accords have partly destroyed this system being of spe-
cial value for the SME sector. But in the meantime at
least the smaller financial institution s have realized that a
return to such a system perhaps leads to a decreasing rate
of return but to more safety in investments and higher
customer satisfaction.
14According to the Chinese central bank the share of regular bank loans
decreased to 58 percent in 2012 (from 95 percent in 2002).

Institutional Economics, Risk Management, and Breakdown of Corporate Social Responsibility:
Towards a New Architecture of Financial Markets
199
Hence, the SME sector needs small and medium-sized
banks (SMB) with managers being closely connected to
the clients and knowing th e individual risk profiles. Mu l-
tifold securitization bears enormous information losses
and the risk of misuse. Multi-agent systems formed by
shadow banks and CRA are suffering from serious prin-
cipal-agent-problems, which are difficult to be adequately
controlled by governmental regulation. The influence of
agents not adequately controlled contributes to specula-
tive bubbles, pyramid and avalanche effects so that the
fundamental economic data are not any longer of rele-
vance for the stock markets and the firm’s capitalization.
Short-termed speculative interests are then endangering
the long term wellbeing of whole societies.
SME as well as SMB have to be supported in the de-
velopment process until they form the backbones of the
economy and a fruitful development strategy. Conven-
tional banking methods have to be combined with mod-
ern financial products, which have to be characterized by
an adequate rate of return and a transparent risk-reward
ratio. Also co-operative credit institutions acting in the
interest of the bank clients are a promising approach to
limit the influence and the con centration within the glob-
alizing market, which principally creates advantages
even for smaller states to get access to the international
capital and to overcome situations of national capital
shortages. But as important as an efficient SMB system
is the trust or mistrust of citizen and business manage-
ment into the national governance system.
Finally it has to be mentioned that neither the US nor
the EU in the future will be the “nucleus of the world”.
Other regions and emerging countries like China are able
to create their own financial architecture, which perhaps
might be quite similar to the proposed model in this pa-
per. Then international liquidity is better allocated even
in favor of such upcoming nations, which also would
guarantee for a sufficient and fair real return on invest-
ment to encourage the global savers and investors for
additional achievements and to produce increasing wel-
fare for a better world.
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