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Abstract

  1. Top of page
  2. Abstract
  3. Question one: why is there no world financial authority on the model of the World Trade Organisation?
  4. Question two: what went wrong in the area of international collaboration?
  5. Question three: will the changes so far agreed by the G20 have the required effect?
  6. Question four: what regional and local changes are needed to make global financial regulation work at country level?
  7. Conclusions
  8. References
  9. Author Information

Abstract

Recent events have once again highlighted weaknesses in the global regulatory system. The highly complex network of bodies overseeing different parts of the financial markets failed to identify or respond to the macro trends that led to the crisis. There was too little capital in the banking system. There is also a serious accountability gap, with regulatory bodies free to work to their own timetables. And the links between macroeconomic policy makers in finance ministries and central banks, on the one hand, and regulators on the other, have been too weak. The changes made so far by the G20 summits are very modest and are unlikely to correct these flaws. There remains a particular problem in the European Union, where the crisis has shown that the single financial market requires more central coordination of regulation than the politicians have so far accepted. There remains, therefore, much unfinished business in financial regulatory reform.

Policy Implications

  • • 
    The Financial Stability Board needs more authority to coordinate the activities of the sectoral regulators.
  • • 
    Financial regulation must in future be more sensitive to changing macroeconomic conditions.
  • • 
    There is a need for an absolutely higher level of capital in the banking system.
  • • 
    Europe needs a central regulatory authority, if the single financial market is to survive in its present form.

One widely accepted conclusion emerging from analyses of the financial crisis that began in 2007 is that the international networks of regulators have not kept pace with the increasing globalisation of financial markets, and that there was a lack of effective coordination of national responses to the series of collapses and explosions that have disrupted the global economy in the last two years. Furthermore, in the lead-up to the crisis, regulators had not properly understood the way in which risks were transferred across borders and between different types of institution. The risk characteristics of new instruments designed to transfer risk were poorly understood. The interaction between global imbalances and credit expansion and asset price bubbles had not been properly appreciated. And institutional bankruptcies of global firms revealed fundamental problems relating to the interfaces between legal and bankruptcy regimes in the different countries in which they were active. Legal cases continue in an attempt to resolve those incompatibilities, and are likely to be with us for some years to come.

So it is clear that there are fundamental problems in the world of international financial regulation, problems that cannot be resolved by bolting yet another committee or working group on to the existing structures. The network is complicated enough already (Davies and Green, 2008). And the problem that the picture in Figure 1 reveals is not the lack of global bodies; it is the absence of any hierarchy between them, or of any central body with the authority to require any of the other organisms to act, on any particular time frame. The relationships between the different regulatory groups are accurately conveyed by the dotted lines on the chart. No one is in charge of anyone else. As a result, there is no sense of urgency or prioritisation built into the system. The Basel Committee took 12 years to revise its capital accord, during which time the banking markets changed dramatically, and a massive parallel banking system emerged, creating huge amounts of credit outside formal institutions.

image

Figure 1.  Global committee structure: a regulator’s view. Source: Adapted with permission from Sloan and Fitzpatrick in Chapter 13, The Structure of International Market Regulation, in Financial Markets and Exchanges Law, Oxford University Press, March 2007.

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What we now have is evidently a messy compromise between the needs of financial markets for global coordination and the protectiveness of national governments, which are concerned not to lose control of their financial systems, regarded by them as essential for the proper functioning of their national economies. In two other articles in this issue, Andrew Sheng and Eddy Wymeersch accurately portray the difficulties of operating within this complex web. Sheng was at the Malaysian Central Bank, and was then chairman of the Hong Kong Securities and Futures Commissions. Wymeersch has chaired the Belgian Banking, Finance and Insurance Commission for many years, and was chosen by his peers to be chairman of the Committee of European Securities Regulators. Both are perfectly placed to convey an accurate impression of how it feels to operate in this environment. Wymeersch describes the interaction between European structures and the global networks, and the struggle to define a clear articulation of responsibilities between the different tiers of regulation. Sheng shows how Asian countries are being challenged by new structures and systems, and how they will need to respond with more regional cooperation on the one hand, and more national awareness of global trends, on the other.

Their work demonstrates, however, that there are some important overarching questions to address. Wymeersch refers to ‘the absence of a worldwide regulator’ (2010, p. 201), and to the halfway house of the European regulatory structure as it will exist after the de Larosière report. Sheng also notes that gap, and the often fragile basis of international agreements. He argues that the architecture of regulation will have to change nationally, regionally and globally, and that Asian countries will need to rethink the way they interface with the global bodies of which they will now become members, often for the first time. Underlying their assessments are four big questions, to which the answers are still unclear.

Question one: why is there no world financial authority on the model of the World Trade Organisation?

  1. Top of page
  2. Abstract
  3. Question one: why is there no world financial authority on the model of the World Trade Organisation?
  4. Question two: what went wrong in the area of international collaboration?
  5. Question three: will the changes so far agreed by the G20 have the required effect?
  6. Question four: what regional and local changes are needed to make global financial regulation work at country level?
  7. Conclusions
  8. References
  9. Author Information

Even in the darkest days of the crisis in the autumn of 2008, the case for some kind of world financial authority remained ‘the love that dare not speak its name’. While heads of government convene regularly to bemoan the lack of effective oversight of global markets, none of them yet draw the conclusion that a supranational authority is needed, even though the case for one was made a decade or so ago in the aftermath of the Asian financial crisis.1 Yet in the case of trade agreements governments have accepted that there is a need for an international oversight body, with hard-edged powers to regulate and settle disputes – the World Trade Organisation. In the field of trade in goods and services, governments have concluded that their collective interests are best served by the cession of elements of their sovereignty to an international body. Otherwise they would face a web of bilateral disputes from which no one would gain. In the financial arena, no such conclusion has been reached. Why not?

Part of the reason may be that the International Monetary Fund (IMF) and the World Bank seem to have occupied some of the jurisdictional space. Yet in fact neither of these bodies is a financial regulator in the sense of setting capital requirements for banks, trading practices, insurance solvency rules or accounting standards. They have taken on an oversight role, in monitoring the extent to which countries are meeting the standards to which they have notionally signed up, but they have no role in sanctioning noncompliers and are not themselves involved in setting those standards. All the standard setters themselves, whether the Basel Committee, IOSCO or whoever, operate on the basis of reaching consensus among their members, who then agree to comply on a voluntary basis. The Basel rules formally apply only to internationally active banks, and have focused almost exclusively on capital, neglecting other areas such as liquidity.

There is some element of discipline within the system in that banking regulators may prevent banks that do not meet Basel standards from setting up in their jurisdictions, but even that sanction is not always applied, and may be overridden by bilateral political pressure. In some countries, also, even agreements reached by their competent authorities may well be disowned or countermanded by domestic political pressure. And here we are not talking about small countries with little influence on the global scene, but about the United States and the European Union. It was clear in the later stages of the Basel II process that the US Congress felt in no way constrained by agreements reached by the Federal Reserve and the Office of the Controller of the Currency over years of international negotiation. The German government complained loudly about the impact of Basel 2 on lending to small and medium-size firms in Germany.

But the fundamental reason seems to be that governments are not prepared to accept that they should cede any element of control over their domestic financial systems to bodies in which they have only a minority interest. Finance is seen to be ‘special’, perhaps because when things go wrong, as we have very clearly seen in the last two years, the costs incurred by governments and their taxpayers in relation to financial rescues may be very high. Solvency support arrangements are national. Sheng argues that another reason is that while there is global consensus that free trade is beneficial for all, ‘There is no global consensus on whether financial flows have the same benefits’ (Sheng, 2010, p. 191).

Our reluctant conclusion must be that, in spite of the crisis, we have in fact moved further away from establishing a ‘World Financial Authority’, rather than closer to it. In current circumstances, when taxpayers are still footing the bill in the US, the UK and elsewhere, any abandonment of the national veto would be difficult to sell to the electorate. We have to accept, therefore, that for the foreseeable future we are in a second best world. As Wymeersch says (2010, p. 201), ‘The creation of some form of [World Wide Regulator] cannot be excluded one day’, but that day has not yet dawned.

In seeking to build on what we have, we need to tread carefully. It would be easy to think that yet another coordinating group could resolve the problems, but almost certainly wrong. So in seeking to improve the functioning of the second best architecture we have, we need to be very precise about what the major malfunctions, as revealed by the crisis, were.

Question two: what went wrong in the area of international collaboration?

  1. Top of page
  2. Abstract
  3. Question one: why is there no world financial authority on the model of the World Trade Organisation?
  4. Question two: what went wrong in the area of international collaboration?
  5. Question three: will the changes so far agreed by the G20 have the required effect?
  6. Question four: what regional and local changes are needed to make global financial regulation work at country level?
  7. Conclusions
  8. References
  9. Author Information

There is no plausible one-sentence answer to the question: why the crisis? A complex failure of this kind has many causes. Many of the problems lie in the way in which firms themselves behaved, and in failures of governance and risk management. But the relevant question here is rather narrower. It concerns only the international collaboration angle. In what sense can we trace the crisis to problems in the networks of collaboration portrayed in Figure 1?

I have referred already to one dysfunctional feature – the length of time that the Basel Committee took in devising a new capital accord. That, as I have suggested, points to a lack of authority and discipline within the system. But delay in creating Basel II might not in itself have been a fatal flaw, especially as the accord itself was generally unhelpful in its procyclical character. A more fundamental point is that the capital accord missed elements of credit creation outside the banking system – securitised investment vehicles and the like. And, perhaps even more significantly, it lacked a clear macroeconomic framework. It may seem surprising to an outsider, and certainly seems astonishing in the light of more recent debates on the appropriate level of capital adequacy for internationally active banks, but the Committee began with an assumption that the total amount of capital in the global banking system should not be reduced and was broadly appropriate, and that its task was therefore to work on improving the distribution of that capital in the light of developing knowledge of risks and losses in the banking system.

There was no debate in the Basel Committee about whether, in the light of macroeconomic developments, changing patterns of credit creation and risk transfer, the aggregate capital of the banking system was appropriate or not.

This, in turn, points to what I see as the most fundamental problem; that is, a lack of interface between those who reflected on the shape of the global economy, the emergence of financial imbalances, the evolution of asset prices and the price of risk, and those who set the basic regulatory frameworks within which firms are required to operate. So, for example, even though economists at the Bank for International Settlements pointed to the emergence of asset price bubbles, whether in the housing or equity markets, in many countries those insights were not seen as relevant to the banking supervisors who determined capital requirements. Many papers were produced by BIS economists and others (Eatwell and Taylor, 2000), but they did not lead to action by banking regulators; indeed there is no evidence that they were even considered by them.

On this analysis, the key improvement required is a far tighter link between finance ministries and central banks in their macroeconomic policy role on the one hand and regulatory standard setters on the other. We must ensure, in the future, that regulation is sensitive to changing macroeconomic and market conditions. Assuming that the amount of capital in the system is right for all time and in all circumstances simply will not do in the future. We must also try to ensure that capital rules do not allow loopholes through which firms can game the system, creating off-balance sheet vehicles that evade capital requirements. If those are the key requirements, we need to ask a third question.

Question three: will the changes so far agreed by the G20 have the required effect?

  1. Top of page
  2. Abstract
  3. Question one: why is there no world financial authority on the model of the World Trade Organisation?
  4. Question two: what went wrong in the area of international collaboration?
  5. Question three: will the changes so far agreed by the G20 have the required effect?
  6. Question four: what regional and local changes are needed to make global financial regulation work at country level?
  7. Conclusions
  8. References
  9. Author Information

The prudent answer to that question, and certainly the one that a cautious regulator would give, is that it is too early to say. The membership of these bodies has been broadened, but so far the most significant architectural change, and it is scarcely even that, has been to rename the Financial Stability Forum as the Financial Stability Board. (In our book on global financial regulation, Green and I recommended an upgrade to a Financial Stability Council as a signal of its centrality in the regulatory universe. The change now agreed is substantially the same (Davies and Green, 2008).)

Whether this change will deliver any significant consequences on the ground will depend on how the Board functions, which will in turn be influenced by the behaviour of G20 finance ministers, since the other significant change has been the effective replacement at the apex of the global financial pyramid of the G7/8 by the G20. This is positive, in that it brings a broader range of countries into the standard-setting machinery. That is important, in that it is unreasonable to expect full-hearted support for global standards from major countries like China and India that have not been in any way involved in their development. Sheng well describes the past relationship between Asian regulators and the international bodies and the way that is changing now.

But the history of the last two decades is of only intermittent involvement by governments in financial regulation. At times of crisis, the issues come into sharp focus, but they can easily drift away again in calmer times. What is needed is a more consistent interest in regulation on the part of finance ministers in the countries that host important financial markets, in a way that empowers the Financial Stability Board to exercise some discipline on the rest of the structure, and to ensure that macroeconomic considerations are to the fore. Up to now, groupings like IOSCO and the Basel Committee have been very reluctant to accept any instructions, or even advice, from the Financial Stability Forum. Central bank governors have tended to see the Bank for International Settlements in Basel as the key forum, and their engagement with the details of banking supervision has been episodic and often rather distant. Monetary policy has been their first, second and third priority. That will need to change.

Perhaps the most important developments have been the global agreements, at least at a level of principle, that there is a need for absolutely more capital in the banking system, especially for large, systemically important institutions, for higher quality capital and for a macro-prudential dimension to banks’ capital requirements (Basel has also now proposed quantitative liquidity requirements). While the capital rules so far have focused on the risks in individual institutions, in future there needs to be an overall macro context within which those requirements are set. So, for example, if these asset markets and credit markets are exhibiting signs of overexcitement, it might be appropriate to impose an across the board supplement to capital requirements in an attempt to dampen the market enthusiasm. Such a tool could be a useful supplement to the manipulation of the short-term interest rate as a means to promoting financial stability.

But we should not underestimate the challenge this process will pose to the existing regulatory networks. In effect, a macro-prudential supplement to capital requirements would be a tax on banks. And it would be tax agreed internationally yet imposed nationally. It needs to be fair globally, for competition reasons, yet applied with sensitivity to local conditions. The application of a macro-prudential mechanism must also be coordinated with monetary policy decisions at national level. An across the board increase in capital will tighten monetary conditions. It is an open question as to whether the G20 leaders who have enthusiastically advocated this approach have fully understood the implications. Certainly, it will be a big test for the Financial Stability Board and whichever group under its auspices takes the lead in devising an appropriate mechanism. It will be absolutely essential for the global decision-making process to feed into regional and national structures. That brings us to the fourth question, which arises directly from the articles by Sheng and Wymeersch.

Question four: what regional and local changes are needed to make global financial regulation work at country level?

  1. Top of page
  2. Abstract
  3. Question one: why is there no world financial authority on the model of the World Trade Organisation?
  4. Question two: what went wrong in the area of international collaboration?
  5. Question three: will the changes so far agreed by the G20 have the required effect?
  6. Question four: what regional and local changes are needed to make global financial regulation work at country level?
  7. Conclusions
  8. References
  9. Author Information

Sheng argues that the regional architecture in Asia will have to change, so that the Financial Stability Board model is replicated in some way at regional and national level. He argues that ‘Asia needs a system-wide view of financial stability, both at the national and regional levels’ (Sheng, 2010, p. 191). There will need to be robust regional structures to ensure that the views of individual countries are fed up to the global bodies. At present, IOSCO has a system of regional committees of securities regulators, but those committees have been largely informal talking shops in the past. Although there have been meetings of informal groups, there is no comparable framework for banking supervisors or indeed for central banks. Those networks will need to be put in place. That will require a step change in collaboration between Asian countries.

In Europe, as Wymeersch points out, there are already both formal and informal structures in place. But his description reveals a continuing problem. In Europe the position is very different from that which obtains elsewhere. The principle of the European single market is that a firm authorised to do business in one country of the European Union is able to transact that type of business in all other countries, using a passport. So a bank authorised in one state of the European Economic Area (which in fact is the relevant jurisdiction, rather than the European Union itself) is able to take deposits in any other European country, through a branch, not requiring a separately capitalised subsidiary. The security of those deposits is the lender of last resort, and ultimately the government of the home state. The host country has no direct purchase on a bank authorised elsewhere in Europe. It cannot require capital to be held in the country where deposits are being taken.

The flaw in this model was revealed by the collapse of the Icelandic banks, where it was apparent that the Icelandic government was not in practice able to compensate British or Dutch depositors for their losses. The Icelandic banks had outgrown the capacity of the local authorities to support them. Each of the two largest banks had liabilities totalling over seven times Icelandic GDP. The British government had to step in, even though the banks concerned had not been authorised or regulated by the Financial Services Authority in London. (The responsibility for these losses is a matter of continuing dispute between the British, Dutch and Icelandic governments.)

These problems, and related issues in eastern Europe where some western European banks withdrew liquidity from local markets at the height of the crisis, led to the de Larosière report, whose principal conclusions Wymeersch describes. De Larosière recommended a European Financial Stability Council, chaired by the president of the European Central Bank, and the establishment of three ‘authorities’ (although as Wymeersch points out they have no authority in the normal sense of the word) and a framework for binding arbitration, whereby a majority of European regulators could require a country to recapitalise a bank whose solvency was in question.2 This proposed arrangement was controversial in some countries, notably in the UK, where it was seen as a breach of the principle that individual member states are responsible for taxation and public expenditure in their countries.

So, for the time being, an uncomfortable compromise has been reached, and it is hard to escape the conclusion that if the single financial market is to work effectively in the future, along the lines envisaged by its architects, then some form of central European regulatory authority will certainly be required. At present, while the enthusiasm for any treaty change is muted, to say the least, after the referendum problems in France, the Netherlands and Ireland, it is almost impossible to imagine the cession of powers over domestic financial institutions to any central EU body. But the logic of such a change is clear, and the alternative is unattractive. If governments believe that they are at risk of having to provide financial support to an institution supervised elsewhere, then they may simply insist that the bank operates through a separately capitalised subsidiary, with capital within the grasp of the host regulator and host government. In theory, such an obligation cannot be imposed within the European Union. But in practice it could be, for if a government and its regulator publicise the fact that they lack confidence in the safety and soundness of a deposit-taking institution on their patch, so to speak, its ability to raise deposits in that jurisdiction would be fatally prejudiced. Forced subsidiarisation would reduce the efficiency of capital utilisation in Europe and impose extra costs on the customers of European banks, but in the absence of an agreed pan-European resolution mechanism, and bearing in mind the diversity of national bankruptcy laws, it may in practice be the most realistic option.

Europe is therefore once again at a turning point. If the single market, which has brought considerable benefits in terms of enhanced cross-border competition, is to continue, then it seems clear that new central regulatory organisations will be needed. The political will may be weak, but the financial logic is strong, and it is particularly strong within the euro area. Cross-border retail business has, not surprisingly, developed more quickly in the single currency countries than it has elsewhere. The absence of foreign exchange risk removes one significant barrier. So it is possible that, under the auspices of the European Central Bank with its new European Systemic Risk Council, more pan-European arrangements will be devised. If the United Kingdom, which has so far been the most hesitant to endorse any form of pan-European regulation, remains fundamentally opposed, then there is a clear risk that euro area structures will be devised which exclude the countries that have no plans to adopt the single currency.

Conclusions

  1. Top of page
  2. Abstract
  3. Question one: why is there no world financial authority on the model of the World Trade Organisation?
  4. Question two: what went wrong in the area of international collaboration?
  5. Question three: will the changes so far agreed by the G20 have the required effect?
  6. Question four: what regional and local changes are needed to make global financial regulation work at country level?
  7. Conclusions
  8. References
  9. Author Information

It can be seen, therefore, that the questions surrounding the appropriate structure for international financial regulation raise major political issues. How far should countries be prepared to pool sovereignty to achieve more robust financial regulation and guard against financial instability on a global scale? How do we reconcile the clear advantages of common rules with the need for strong domestic accountability for all decisions that involve or may potentially involve taxpayer support? As Mervyn King, the Governor of the Bank of England, has pointedly and wittily observed, financial institutions are global in life but national in death. In other words, the obligation to bail them out of terminal difficulty falls back on the home authorities, even if the problems have emerged in their overseas activities.

Within the European Union there is a related, albeit somewhat differently configured, issue involving the desired end point of the single market. Is it possible to have free and open markets within Europe, without a central authority to set capital rules for individual firms to ensure that competition is carried out on a level playing field? Has the financial crisis revealed a fundamental flaw in the regulatory organisation of Europe?

So far, the G20 leaders, while appearing to address the global questions raised by the crisis, have in effect avoided these major issues. We cannot say, therefore, that we have reached a comfortable resting place. There is much unfinished business.

Footnotes
  • 1

     E.g. Credit Risk Transfer; Committee on the Global Financial System, Paper No. 20, January 2003 (http://www.bis.org).

  • 2

     Report of the High-Level Group on Financial Supervision in the EU, chaired by Jacques de Larosière, Brussels, February 2009.

References

  1. Top of page
  2. Abstract
  3. Question one: why is there no world financial authority on the model of the World Trade Organisation?
  4. Question two: what went wrong in the area of international collaboration?
  5. Question three: will the changes so far agreed by the G20 have the required effect?
  6. Question four: what regional and local changes are needed to make global financial regulation work at country level?
  7. Conclusions
  8. References
  9. Author Information