De-regulation is dead. Twenty years after the fall of the
Berlin Wall, financial laissez faire has joined communism in
the graveyard of failed ideologies.
After the worst financial crisis since the Great Depression,
it is hardly surprising that the debate is over how, rather
than if, financial institutions and bankers should be more
There has certainly been no shortage of ideas. US president
Barack Obama and his Treasury secretary Timothy Geithner spelt
out a tough new approach in a report entitled A New Foundation.
Jacques de Larosiere, the veteran French civil servant and
banker, wrote a report for the European Commission proposing
the creation of a systemic risk council to spot impending
crises. In the UK, one of the worst affected victims of the
crash, Adair Turner, chairman of the Financial Services
Authority, has floated the idea of a global tax on financial
transactions to eliminate excessive activity and
Finally, after a lot of political bickering, leaders of the
largest economies drafted an overarching vision at the G-20
finance ministers meeting in London and reinforced it at the
summit of leaders in Pittsburgh. It covers a vast range of
measures, notably tighter capital standards, stronger
regulation for systemically important firms, and rules on pay
that do not encourage risk taking.
We have made substantial progress in delivering our
ambitious plan, which will ensure a robust and comprehensive
framework for global regulation and oversight, finance
ministers said in London.
Not so sure
Not everyone is so impressed. While theres a lot
of talk about regulation, they are not getting on with
it, says Raghuram Rajan, a former chief economist at the
IMF and now a professor at Chicago University.
Simon Johnson, Rajans successor at the IMF and founder
of the much-watched Baseline Scenario blog, sees little more
than small changes.
What will really change in or around the power
structure of global finance as it plays out in the
United States, western Europe or anywhere else?
He cites as evidence the lack of massive PR campaigns
against the proposals from the leading financial institutions
whose well-oiled lobby groups typically waste little time
Unless and until our biggest financial players are
brought to heel, we are destined to repeat versions of the same
boom-bust-bailout cycle, he says. If you find a
government willing to state this problem clearly and really
take action to confront the relevant powerful people, let me
The Institute for International Finance (IIF), which
represents 400 global finance houses, says the notion of
reckless financiers is one of the many caricatures
used by the industrys critics. One of the
caricatures is that we are opposed to reform, opposed to high
capital requirements, opposed to lower leverage, opposed to
transparency and opposed to macro-prudential regulation,
says Charles Dallara, the IIFs managing director.
In fact, important and substantial changes [by banks]
have taken place and are taking place: reduced leverage,
prudent lending practices, $650 billion of capital raised,
strengthened business models, improved governance and better
Stephen Lewis, an economist at Monument Securities in
London, says the G-20 can hardly be blamed for spinning the
reform process out. They do not want lenders to have to
meet tougher capital requirements as long as economic
conditions remain fragile, he says. After all,
lenders might meet the more stringent requirements only by
scaling back their lending.
While the G-20 and the Financial Stability Board
(FSB) that drew up the detailed plan unveiled at Pittsburgh
work on their vision, it is up to national governments
to put in place legislative changes needed in their own
jurisdictions. And national measures have to fit with a
countrys individual circumstances and the deep-seated
ideological preferences of its electorate.
The three key issues that ministers must tackle are: capital
requirements and liquidity standards; supervision of
cross-border resolution of systemically important firms; and
the whole issue of remuneration for financiers.
Many fear the high-profile arguments, such as those on
capping bonuses, make a global deal hard to reach. There
could be a significant improvement in coordination,
Dallara says. The bulk of what has been done over the
past two years on regulatory reform has been done in an
uncoordinated, nationally driven fashion.
This fragmentation has many symptoms. Proposals to curb
bankers pay are a key area where countries have diverged.
France has adopted unilateral rules on bankers pay, while
Britain and America believe restricting banks risk-taking
activities will do the same job indirectly.
The G-20, as a sop to France and Germany, asked the FSB to
explore possible approaches to capping
Peter Hahn, a former senior corporate finance officer at
Citigroup and now a Fellow at City University in London, says
France is going down the wrong track. Pay is a symptom;
it is not a disease, he says.
But Joseph Stiglitz, Nobel laureate and professor at
Columbia University in New York, believes the French have taken
the right approach. The French government and some of the
other European governments have shown more resolve to do
something about the compensation problem, he says.
Rajan says the problem is that the proposals range from the
very light to the draconian. It is not clear
that the people who have thought about the draconian stuff
understand whether this will resolve the problems seen during
the crisis or whether the only point is merely to get at the
bankers themselves, cut them down to size because they hate
banks, he says.
Another area of disagreement is over leverage ratios: a cap
on the amount of debt an institution can hold relative to its
equity. Geithner has proposed a simple leverage
constraint that would act as a hard-wired
dampener on unsustainable risk-taking. Continental
Europeans on the other hand want leverage seen as part of a
risk-based approach and included under the so-called pillar two
of the Basel II accord, with flexibility to impose tighter
rules on different banks.
Speaking for the big banks, Dallara praises the European
option. Leverage is a blunt instrument, he says.
Leverage with a balance sheet full of Treasury bills and
European government bonds is very different from a balance
sheet full of highly complex derivatives.
Leverage ratios are just one part of requirements for banks
to hold more and better quality capital. This is a central
element of the US and UK plans. A new US Financial Services
Oversight Council would apply tough capital, liquidity and
risk-management standards to large, high-leveraged or complex
organizations whose failure would threaten the stability of the
Geithner has set out a detailed proposal for a new capital
requirements regime that includes eight core high-level
principles. He said the Treasury would strike a balance
between absolutely essential higher capital
requirements needed to underpin financial reform and
unduly curtailing credit availability and financial
British chancellor Alistair Darling is instructing the
Financial Services Authority (FSA) to place higher capital
requirements on banks with higher requirements for those
involved in riskier trading activities.
However, there are no detailed proposals on the table and no
imminent sight of any. Geithner has said that countries should
achieve a comprehensive international agreement on a new global
framework by the end of next year, with implementation of the
reforms effective by the end of 2012.
Stiglitz says the devil is in the detail. There are
statements like we are going to order more capital for
larger institutions, but until we see how much more
capital we wont know whether it will bite, he says.
Until we see the details, we wont know whether this
is just a cover-up or whether it is meaningful.
Rajan warns against setting levels of capital that guarantee
against failure. The levels of capital you would need to
prevent failure would be totally enormous, and asking banks to
hold those levels of capital could mean a doubling of capital
requirements, he says. It might need a rethinking
about whether people want financial intermediation. People act
as if capital is a free good.
The lesson of the collapse of Lehman Brothers on September
15, 2008 was that it is vital for governments to have a
contingency plan for a failure of a systemically important
institution especially where its operations cross
Governments should not be left with the choice between
chaos breaking out or bailing out a global financial
institution. There is a third way and that is the development
of resolution regimes, says Dallara. We need to
begin our work with private and public sectors on cross-border
crisis resolution regimes that are compatible and mutually
The UK designed a Special Resolution Regime in the wake of
the Northern Rock fiasco and put it into operation to rescue
the Dunfermline building society. Darling is also considering
whether to force banks to make living wills to make
it easier for the authorities to dismantle failed firms. The US
is pursuing the same idea.
The European Commission is also struggling with how to
oversee rescues of banks that may operate in several small
member states but be based in one the so-called
home/host problem. The de Larosiere report noted there were no
EU-level mechanisms for financing cross-border crisis
resolution efforts, but concluded only that member states
should agree on more detailed criteria for sharing the
Dallara says this is a crucial issue. What kind of
burden sharing [is there] if a subsidiary in country A of a
host bank in country B fails? We need to work towards a
system, he says. It is ambitious, but it is
necessary. In their absence you have a tendency towards
fragmentation and policies designed to protect one country
rather than protecting the system as a whole.
While coordinating 20 governments may seem hard, for US
president Obama the stiffest opposition may be at home. He
plans to strip the Securities and Exchange Commission of its
role as the bank rescue agency and pass it to the Federal
Reserve, which also takes on payment and clearing system
oversight. This has angered some in Congress who believe the
Fed is being beefed up without acknowledgement of its role in
inflating the asset price bubble.
Meanwhile a new Consumer Financial Protection Agency that
will protect consumers and investors from financial abuse is
being resisted fiercely by mainstream banks.
The American Bankers Association (ABA) believes reforms
aimed at curbing the excesses of the non-banking institutions
will harm the wider economy. The Administrations
proposal is so vast and controversial that it will be extremely
difficult to enact and will produce great uncertainty in the
financial markets and among financial regulators while it is
pending, says Edward Yingling, ABAs chief
executive. Thousands of banks of all sizes, in
communities across the country, are scared to death that their
already-crushing regulatory burdens will be increased
dramatically by regulation aimed primarily at their
less-regulated or unregulated competitors.
But Peter Hahn says these detailed arguments are a side
issue to a bigger failure. Policy-makers have failed to adopt
genuinely radical solutions to avert a repeat of boom and bust,
he says. Governments need to break their dependence on the
financial system and force banks to become smaller and more
What the G-20 is really trying to do is smooth things
over and take the easy option because they cannot think outside
the box. The reality is that they need to reinvent the whole
model, he says.