In normal times, political leaders show very little interest in the arcane details of international financial regulation. The worst global financial crisis since the 1930s has changed that.
When the G20 leaders held their first meeting, in Washington in November 2008, they focused almost exclusively on financial regulatory reform issues. This topic has remained at the centre of every G20 leaders’ summit since, and it will be just as important in Toronto in June. Although some important progress has been made, the G20 has yet to tackle some of the most important, but also most difficult, parts of the reform agenda. These relate mostly to the implementation of macro-prudential regulation.
Before the crisis, international financial regulation primarily concerned the stability of individual financial institutions. The 2008 crisis highlighted the need to complement these micro-prudential rules with macro-prudential ones that protect the stability of the system as a whole.
One example is the proposal to require banks, in good times, to build up buffers that can cushion them in times of stress and thus help to minimize self-reinforcing credit booms and busts. The G20 has endorsed the use of such “counter-cyclical” buffers, but has yet to agree on how to implement them.
The Post-crisis Financial Landscape
An even more important unresolved area is the treatment of what are now called “systemically important” financial institutions. The crisis highlighted very clearly the social and financial costs, both to the taxpayer and the wider economy, when these institutions collapse. The G20 leaders drew the important lesson that these institutions must be subject to special kinds of regulation. At the Pittsburgh summit in September 2009, they concluded that “our prudential standards for systemically important institutions should be commensurate with the costs of their failure.” They set the end of 2010 as the deadline for reaching agreement on how to regulate them.
The urgency of this task has grown. The post-crisis financial landscape is populated by even larger and more interconnected financial institutions than before. Further, they are more keenly aware than ever that, due to their systemically significant status, they are backed by implicit state support. The result is a massive “moral hazard” problem in which large financial houses may resume excessively risky activities, expecting taxpayers to pick up the tab for mistakes.
Creating an international consensus on this issue has proven very difficult. Some policy makers favour breaking these institutions up, while others want to restrict large banks from high-risk, casino-like activities. Still others prefer simply to subject these institutions to tighter supervision and regulation. There is also growing support for rules that force these institutions to pay for bailouts and to prepare “living wills” that outline how they will be wound down in times of trouble.
The G20 leaders must ensure that the heated debates on this topic within and between countries do not end up delaying, or even inhibiting altogether, reform in this area. In the areas where consensus is emerging (for example, tighter capital standards, leverage ratios, living wills) detailed international rules should be locked in as quickly as possible.
In other areas, it may be more politically realistic to push for vaguer, principles-based standards allowing countries more policy space to choose their own approach, but which still make sure that action is taken. This policy space may include giving national regulators more power to regulate international banks on a “host-country” basis. If, for example, consensus cannot be reached on international levies to fund future bailouts, national regulators may prefer to force foreign bank branches to be transformed into subsidiaries regulated by the host country and backed by local capital that can be mobilized in times of trouble.
The importance of creating international standards on macro-prudential issues — even if only at a principles-based level — cannot be overstated. After the global financial crisis of 1997-1998, policy makers also expressed their desire to address systemic risks. Once the memories of the crisis faded and the urgency of reform dissipated, however, regulators lacked the tools and incentives to address the build-up of systemic risks, despite various warnings from bodies such as the Bank for International Settlements.
This mistake can be avoided by hardwiring a focus on systemic risks into the international regulatory architecture. Of course, international financial standards are merely “soft law” without enforcement mechanisms, but they are widely followed and may be even more so in the coming years because the Financial Stability Board (FSB), created by the G20, has developed new mechanisms for encouraging compliance, including a new peer review exercise.
If macro-prudential regulations are to be implemented effectively, the G20 must confront a final, and more political, issue more squarely. Macro-prudential regulation requires regulators to take a strong stance against market trends, such as cyclical booms or growing concentration and risk-taking within the financial system. If regulators’ relationships with private market actors are too cozy, this role will not be performed well.
In their reform discussions, the G20 leaders have yet to address the risk of private sector “capture” of regulatory policy making directly. The neglect is odd given how many analysts lay considerable blame for the crisis on this very phenomenon.
International standard-setting should tackle the subject explicitly. For example, standards could be developed to address the problem of “revolving doors” by requiring mandatory public disclosure of all past and present industry ties of regulators, and/or specifying a minimum number of years before regulators can shift to private-sector lobbying and vice versa.
International standards for counter-cyclical buffers could also encourage their adjustment based more on rules rather than discretion in order to help regulators resist private lobbying. Standards that reduce complexity and opacity — such as simple leverage rules, or forcing credit derivatives onto exchanges — will also constrain the ability of market participants to dominate regulatory debates through their expertise. In addition, international regulatory bodies, such as the FSB, could make greater efforts to counter-balance private sector influence by consulting with other societal groups as well.
There is, thus, much to be done on the international regulatory reform agenda at the Toronto G20 summit. 2010 will likely be seen in retrospect as the decisive year that determined whether this post-crisis reform initiative succeeded or failed. Success will only be achieved with strong political leadership coming from the leaders’ level.
Eric Helleiner is CIGI Chair in International Political Economy at the Balsillie School of International Affairs and professor of Political Science at the University of Waterloo, Ontario, Canada. He is author of The Financial Stability Board and International Standards and co-editor of The Financial Stability Board: An Effective Fourth Pillar of Global Economic Governance? (both published by The Centre for International Governance Innovation, June 2010).