On the surface, the global push to implement measures to stem future systemic crises like the one that first gripped the global economy in 2007 has made considerable progress. In a letter released on April 20, 2012, Bank of Canada Governor and Chair of the Financial Stability Board (FSB) Mark Carney summarizes the progress made since the November 2011 Cannes summit. The letter emphasizes the fact that agreement has been reached on general principles to strengthen the resilience of the global financial system, to properly regulate and supervise systemically important financial institutions, and develop the necessary oversight of the shadow banking system. Nevertheless, the continuing crisis in Europe, the recurring worries over whether existing financial “firewalls” are large enough to forestall another global financial crisis and the weakness of the global recovery, suggest that, almost five years since the start of the “global” financial crisis, a safer and stronger global financial system has not yet been achieved. Mark Carney’s letter is also notable for its insistence that “focused attention, sustained effort and effective cooperation will be needed by all of those involved to achieve the promised deliverables” by the time of the next summit in Los Cabos, Mexico. To make matters worse, we are nowhere near a state where reforms under consideration are “timely, complete and globally consistent.” Comments such as these do not inspire much confidence.
Part of the difficulty is the sheer complexity of the issues involved, as policy makers still struggle to define what financial stability means, let alone identify institutions that are systemically important. Instead, politicians appear to believe that ever larger “firewalls” will protect the world from another financial crisis and the attendant spillover effects in the real economy. Such an approach is, unfortunately, grossly misplaced. Observers and policy makers are not even able to agree on how big an adequate firewall should be and, in any event, this does not solve the problem of weak banks, inadequate institutions for supervision and a confusing regulatory regime. Quite the contrary — we are witnessing a race to see how far governments are willing to go in defending policies that both markets and the public at large are refusing to accept. If this were not the case, why is it that the crisis continues even after politicians and policy makers insist that the latest measures will solve everything?
Dealing with systemic risks involves recognizing that some of the policies put in place by central banks to support the banking system in the short term, may actually weaken the financial system in the long term by creating zombie banks,[1] as well as make banks appear more susceptible to sovereign risk as they load up on increasingly risky sovereign debt. Indeed, the networking, interconnectedness and herding phenomena built on private claims that brought the role of systemic risk to the forefront of the debate over financial system stability is now being recreated around government debt.
Unconventional policies, such as the European Central Bank’s long-term refinancing operations, provide some breathing room, but unless behaviour changes, these reflect the inability or unwillingness of governments and their central banks to adopt the many laudable goals set out by the FSB. Together with a loss of faith in the ability of governments and policy makers to address the current economic and financial malaise, there is little reason to believe that any progress report delivered in Mexico in June will assuage the continuing global economic gloom. If the world’s largest economic bloc, namely Europe, is incapable of agreeing on a credible way forward to implement a unified system for banking supervision and regulation, which surely must parallel a system with a single currency, then what hope is there for Mark Carney’s call for global cooperation on financial reforms?
Consequently, there exists an urgent need to shift attention away, asking — borrowing from John F. Kennedy’s inaugural speech — not only what governments can do to create a safer financial system, but what markets will themselves contribute to achieve such an outcome.
How can financial markets, and the public more generally, be persuaded that a change for the better is imminent? Communication must be improved. The G20 and the FSB, the body it established, must regain control over the reform agenda it appeared to set so effectively in 2008 at the height of the financial crisis. The early momentum was lost to disagreement, competing proposals, incoherent progress in reforming financial systems, and an uneasy and misguided shift in responsibility to the International Monetary Fund (IMF), which sought to fill a void, not carry out a mandate assigned to it by the G20. The G20 should declare as a strategic imperative the responsibility to protect (R2P) the financial system by insisting that all members individually have a duty to prevent financial crises, while the existence of significant systemic risks create a responsibility to develop principles that can work on a global scale. Rather than work on “minimum” acceptable standards (the current strategy), the FSB should develop a set of principles that not only represent best practice, but that all member countries should aspire to. Instead, in an effort to protect their sovereignty, there is once again opposition to proposed reforms as these are seen to represent a threat to domestic objectives. The foot-dragging extends to reforms of the outmoded IMF Charter. The Charter still reflects its post-World War II roots, dominated by the United States and Europe. The realities of a world where emerging markets, among others, play a much more important role economically has yet to take hold even if, in principle, the concept is understood as one that needs urgent attention. Hence, we are left with an institution that is not credibly able to represent the international community in the area of financial cooperation. No firewall, however large, can change the perception that IMF governance is broken.
Of course, the notion of a R2P may well raise cynicism of the kind levelled at the United Nations R2P initiative in 2005. Partly Canadian inspired, the initiative focused on protecting populations from genocide, war crimes, ethnic cleansing and crimes against humanity. There are, however, at least three reasons to be more optimistic about an R2P for the financial system. First, the G20 is far more representative than the UN’s Security Council. Second, no one is suggesting that failure to implement a sound financial system would result in military intervention. Third, the actual work of defining and creating the conditions for a resilient financial sector is left to technocrats, not politicians. That said, it is politicians who must cede some sovereignty to the G20 and, by implication, to the FSB. Of course, history has shown that this is much easier said than done. Nevertheless, it may be that a body such as the FSB, suitably structured and provided with the necessary resources, can, in cooperation with other international institutions such as the IMF, acquire and disseminate the necessary information to assess the state of reforms worldwide and, if necessary, shame those whose policies do not measure up to best practice. This would also require that member states eventually achieve a level of transparency, accountability and governance that enhances trust in the intention of policy makers to strengthen and improve the resilience of the global financial system. The effort must be global, because increasing the power and responsibility of individual central banks may actually have had the unintended consequence of giving the illusion of improvements in ensuring stability in the financial system. However, without assurances or the means to publicly demonstrate that, when it comes to global finance, we are all in this together, it is difficult to believe that global financial markets will interpret existing efforts as the consequence of a desire for collective action.
[1] These are banks whose survival is overly dependent on holding high quality government debt. As a result, zombie banks are less likely to perform their usual function of providing credit to the private sector.