The communiqué issued after last November’s first summit was vague on financial regulation. It stressed the need for more effective regulation of the financial sector but did not offer a detailed blueprint of financial reform. The second summit’s declarations, the communiqué and the annex titled “Declaration on Strengthening the Financial System” are quite specific. The details of the second summit’s new outline for global financial regulation can be found in the 67-page final report of the G-20 Working Group 1 on “Enhancing Sound Regulation and Strengthening Transparency,” containing 25 recommendations, issued a week before the summit. The second summit, adopting those recommendations, assigned to the FSB a major role in international financial regulation. After defining the broad mission of the FSB, it declared that “members of the FSB commit to pursue the maintenance of financial stability, enhance the openness and transparency of the financial sector, and implement international financial standards … and agree to undergo periodic peer reviews.”
The FSB is the old FSF (see my column “The G-20 economic summit (II),” Nov. 24, 2008), with its membership widened to include the entire G-20 and a mandate strengthened to cover a wider array of financial institutions and transactions. The FSB, as the beefed up FSF, is “to strengthen its effectiveness as a mechanism for national authorities, standard setting bodies and international financial institutions to address vulnerabilities and to develop and implement strong regulatory, supervisory and other policies in the interest of financial stability.” It will act as an international monitoring and coordinating body, advising on best practice regulatory standards, setting guidelines and supporting supervisory colleges, managing contingency planning for global crisis management and collaborating with the International Monetary Fund (IMF) to conduct “Early Warning Exercises.” These exercises, based on global surveillance systems, are aimed at preventing financial stresses from turning into crises.
On the day of the summit, the FSF issued three reports that contained its recommendations and principles to strengthen financial systems, covering (1) “Recommendations for Addressing Procyclicality in the Financial System,” (2) “Principles for Sound Compensation Practices” and (3) “Principles for Cross-border Cooperation on Crisis Management.” It also published an update of its April 2008 “Report on Enhancing Market and Institutional Resilience.” The FSF’s recommendations and principles, offered in support of the action plan adopted by the first G-20 summit, largely formed the basis of the second summit’s deliberations and declarations.
The basic question in the aftermath of the second summit’s specific pronouncements on financial regulatory reform is whether the principles and objectives it espoused will be implemented and, if implemented, prove to be effective. In an editorial, the Wall Street Journal, always leery of tougher government regulation, was dismissive of the summit’s regulatory blueprint centered on the FSB: “ … don’t hold your breath waiting for [the FSB] to write global regulations for hedge funds and all systemically important financial institutions, instruments and markets. That could take awhile.” Keep in mind that the new regulatory framework proposed by the summit is not a supranational one in which an omnipotent FSB rules the roost. It relies on the effective international cooperation of sovereign national standard setting and regulatory agencies to accept and enforce common global regulatory and supervisory standards, assuming such standards can be agreed on.
It will be extremely difficult to get the US Congress -- which is now considering new legislation for comprehensive financial regulation, including a single systemic risk regulator -- to overcome its aversion to global regulation, which it believes could restrict the international competitiveness of the US financial sector. It will definitely resist the adoption of global standards. Under strong lobbying by private equity groups, hedge funds and venture capital firms, which have argued that they pose no systemic risk and were not responsible for the global financial crisis, it might also balk at their stringent regulation -- demanded by the EU, especially Germany and France -- by requiring them to register and disclose their activities. The summit’s blueprint also contains the danger of regulatory arbitrage, when financial institutions shift their activities to those countries that are either unable or unwilling to enforce fully global standards.
Another potential problem is that the new global regulatory and supervisory standards could be dysfunctional in that they raise the likelihood of financial instability and systemic risk instead of lowering them. Such standards, for example those on bank capital requirements, need to be not only countercyclical but largely self-enforcing, based on proper incentives, as has been argued by Professor Raghuram Rajan, former chief economist of the IMF, in his article “Cycle-Proof regulation,” in the April 8 issue of The Economist. (Countercyclical, the opposite of procyclical, refers to prevention of mutually reinforcing interactions between the real and financial sectors that amplify the business cycle fluctuations and worsen financial instability.)
He argues, after warning against the dangers of dysfunctional over-regulation, that the new regulations on capital requirements must be “comprehensive, contingent, and cost-effective.” Professor Rajan is a member of the Squam Lake Working Group on Financial Regulation, made up of 15 US academics at the Center for Geoeconomic Studies of the Council on Foreign Relations (CFR), who have been offering policy advice on financial regulatory reform since October 2008. The three policy papers they have issued thus far can be found at the CFR Web site (www.cfr.org). Similar research-based policy analysis as well as commentary by an international group of specialists on financial system issues, including financial regulatory reform can be accessed on the policy portal VoxEU.org, set up by the London-based Centre for Economic Policy Research (www.CEPR.org) and sponsored by the EU. What remains to be seen is whether: (1) this flurry of academic research will form the basis of effective financial regulation as politicians enact legislation lobbied by powerful interest groups, and (2) the FSB will realize its potential to maintain global financial stability. Don’t hold your breath, especially if the global financial crisis begins to recede soon and we begin to forget about it.
