I will start with two rather separate themes, which I then hope to bring together to confront international problems. The first one derives from the nature of financial regulation itself and the way that the regulators, or regulatory theory and practice, have developed over the past 10, 20 years. It was very well summed up in Alan Greenspan’s confession when he said he had thought that firms would manage their financial risks themselves. That’s revealing in two ways: First of all, it reveals that, like most of the regulatory community, Greenspan had bought the argument that modern risk management technologies, based on statistical financial theory and data processing, have developed techniques that, if applied by firms, would reduce risk for the system as a whole.
What I think Greenspan should have said on that occasion was not « I thought firms would manage »; but « I thought they could manage ». Because one of my two themes is that risk management by firms themselves, however well-practiced and sophisticated, does not reduce systemic risk for the system as a whole. There are risks which the firm itself cannot measure. And the standard bit of theory behind this is the simple economics of externalities, the one about the factory owner who produces dirty smoke, takes into account the cost of mate-rials and the returns that they get from selling the products, but not the cost of the smoke in terms of its impact on the health, on the life quality of the local region and general pollution.
That same idea carries over into finance: the risks that an individual firm takes may be measured in terms of its own risk exposure; but that doesn’t take into account the consequences of its risk expo- sure for the system as a whole. The obvious example is the idea of a bank run: Bank A fails because it has made inappropriate loans or been imprudent. Bank B is perfectly prudent, and solvent, and careful. But because Bank A has failed, everybody starts to think that the whole banking system is not as safe as they thought. They rush down to take all their money out of Bank B, and Bank B fails because it can’t produce the cash fast enough, even though it’s perfectly solvent, per- fectly prudent, and perfectly well-run. So the risks that were created by Bank A included risks to Bank B, which of course it didn’t take into account. It didn’t price. And this is what is meant by systemic risk: it is the risk characteristic of the system as a whole which individual firms, however expert they might be in managing their own risks, cannot actually evaluate. It’s not their fault. They just can’t do it. It’s an externality. It has to be measured and managed by those who manage the market as a whole; in this case, the financial regulators. As I said, the regulators bought into the argument that new risk management techniques were sufficient, but they were not.
That’s the first theme. The other theme is the way in which institutions, international regulatory institutions, have developed since financial markets began the long road to liberalization in the early 1970s. It was in January 1974, after the turmoil at the end of the fixed exchange rate system of Bretton Woods, that financial markets were effectively liberalized one after the other: in the United States, in Germany, in Switzerland and so on. In the next three to four years, most of the OECD countries liberalized and opened their financial market.
The first international financial crisis occurred at the very start of this process, in summer 1974. I’m referring to the so-called Herstadt Crisis: a West-German bank called Herstadt Bank was trading in futu- res on the New York money markets. It got things wrong and it fai- led, and informed its regulator in West Germany about it. The regulator said, « at 4:00 on Friday afternoon, when the exchanges are closed, you will fail, and we will close you down, and then we’ll come in and clean up the operation », not taking into account that at 4:00 on Friday afternoon in Frankfurt, it’s only 10:00 a.m. in New York and the markets are open. You may think this is funny today, but at that time people were sitting in national jurisdictions.
There was consequent chaos on the New York money markets, and settlement procedures froze. The settlement structures of the entire U.S. banking system were threatened by this crisis. The Federal Reserve asked the German Bundesbank what it was going to do about it and the Bundesbank responded: « Nothing. It’s in New York, so it’s your problem. What are you going to do about it?" The Federal Reserve replied: « Nothing. It’s a German bank. It’s your problem ». This was the first time people recognized that you needed some form of international procedure for managing the risks in the new liberalized system.
As a result of that, the G10, a quite unknown international organization composed by the main European countries, Canada, the U.S. and Japan, set up a new organization called the Basel Committee on Banking Supervision, with different committees: one charged with settlements and one with structures of international markets. These committees were set up as an informal system; it was, if you like, committees of consenting adults. What they did was to develop rules. In this case, how to solve the Herstadt risk in a responsible way? Which regulator should be in charge, the home regulator or the host regulator?
Over the next 30 years, these committees have developed more and more rules. For example, they are actually the people behind the definition of the amount of capital the banks must hold, first in the Basel I agreement of 1988 and then the Basel II agreement, which has just come into force, and behind a whole series of other principles and codes that define how banking is supposed to work.
The interesting thing is that this is a consensual organization. It is what the lawyers call soft law; that is, that they develop rules which then have to be incorporated by national jurisdictions into their law. They have no powers as such, and yet they’re the main international rule-making organization.
Then, at the time of the Mexican peso crisis in December 1994, the G7 leaders themselves started to worry about international financial regulation. They hadn’t really been involved as an organization before. Following the 1997-98 Russian and Asian crises, the G7 set up the Financial Stability Forum, a committee which consists of central bankers, regulators, and treasury departments from G7 countries, plus some international organizations like the IMF, the World Bank and the Bank for International Settlements. This organization is really in charge now; it decides what is to be done with respect to financial regulation. It was making the running before the current cri-sis, and they’re making the running now. It published recommendations as to what to do in April 2007 and their recommendations were endorsed by the G7 finance ministers. In October 2008, they publi- shed a follow-up setting the framework for the meeting in Washington that will take place today and tomorrow.
So the Financial Stability Forum is the intellectual force. And they have three basic themes in their argument. The first is transparency, the second is disclosure - there is a difference between transparency and disclosure: transparency is about the instruments you should be able to understand, while disclosure is about revealing the actual procedures of the firm - and more effective risk-management by firms. In other words, they still accept the argument that more effective risk-management by firms, combined with market sensitivity and more information, will be enough. They are ignoring externalities and systemic risk.
The other organization that has become increasingly involved is the IMF. The IMF started reinventing itself around 1998-99 as a financial regulator. It took the intellectual lead from the Basel committees and from the Financial Stability Forum, and used its treaty powers to start doing inspections of countries’ financial systems, the so-called Financial Sector Appraisal Program. They have now inspected financial regulatory systems around the world and produced a whole number of reports. They haven’t done anything, but they have collected a lot of data, actually some rather useful data.
This is the institutional landscape today. We have structured institutions and we have a particular theory. Now the theory is very use- ful, because suppose that we did have an international regulatory organization charged with managing systemic risk, operating at the level of the system as a whole). Let’s take an example of a policy proposal which deals with systemic risk, which is so called pro-cyclical provisioning, requiring banks to put aside more capital in the time of a boon and allowing them to run some of it down in the time of a slump. Suppose you try to implement that policy internationally. It’s easy to do at the national level perhaps - well, maybe it’s not so easy, but you can understand how you can do it legally - but how would you do it at an international level? Suppose, for instance, that one area of the world is in a boon while another area of the world is in a slump. That means the capital requirements will be different in these two parts of the world. And lo and behold, banking operations would move very rapidly into the part of the world which had the lower capital requirements. Which means that once you start thinking about systemic regulation, which is what we need on an international level, then you run into significant difficulties, analytical difficulties. International regulation has developed a framework, a quite successful framework until now, because it hasn’t faced that problem. But the problem is real. International regulation has simply left the control of risk to the firms: all it does is to develop better rules for firms, rather than addressing this systemic problem.
Still, this systemic problem is a major issue. Our liberalized financial markets need regulation to manage systemic risk, but the regulators are still trapped in irrelevant national boundaries, national juridical boundaries. They don’t have international regulatory powers. And therefore you have ineffectual international regulation; you have the ability of financial institutions to practice regulatory arbitrage and to move to those areas where regulation is slacker; and even though there is a clear global connection, especially these days, between the financial markets, it is not matched on the regulatory scale. I said before that the Financial Stability Forum has come up witha framework, essentially the same as the one that had dominated the development of regulation for the last 20 years – transparency, disclosure, riskmanagement by firms – paying no attention to systemic risk. That’s not entirely fair, because they did have one very good proposal which they have actually taken over from some European Union proposals, which is that there should be colleges of supervisors responsible for large international firms. Let’s take HSBC, the biggest bank in the world, stretching all over from Asia into the Americas. Its regulator would be a collectivity of the regulators from its major jurisdictions: a college put together from Singapore,from Hong Kong, from London, from New York and so forth, in charge of regulating that institution. This is an attempt to develop a framework that actually would deal with global institutions.But we do have a problem. There’s a lot of institutions involved, but they don’t have a framework. Apart from this one good idea, they don’t really have a framework within which to operate. The British government’s main line is that the Financial Stability Forum has the ideas and no power, and the IMF has power and no ideas. And therefore the two should be put together, because the IMF is a treaty orga- nization with legal rights and responsibilities, defined by the Articles of Association, and also because it overcomes some of the democratic deficit in the G7 organization. The IMF may have an imperfect governance structure, but at least everybody’s involved; it’s not just the G7 telling the rest of the world what to do.
What we are going to see over the next few years, I think, is a great effort to reinvent the IMF, reinventing it as a financial regulator. Therefore, if we want to influence this debate and develop a structure that actually confronts the problem of systemic risk, that’s where our interests should be targeted.
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