The financial upheavals of the past few weeks have led some to predict that we could well witness a repeat of the global financial meltdown of three years ago. But haven’t G20 policy makers been working diligently since then to make the global financial system safer and more shockproof?
Indeed, they have. Unfortunately, it is far from clear that the thousands of hours of work that have gone into post-crisis regulatory reform have made the system much safer from the kind of instability we are now facing.
Political uncertainties in Europe and the United States have acted as the triggers for the recent financial instability. The failure of European policy makers to arrive at a decisive solution to the financial and political difficulties in the eurozone has unnerved investors. Financial markets were then spooked further by US Congressional budget debates and the prospect of a default on US Treasury debt. These political issues of addressing the eurozone’s internal governance problems or Congressional decision making are well beyond the mandate of the more technically oriented G20-led agenda of financial regulatory reform.
G20 regulatory initiatives might, however, have helped avoid some aspects of this latest crisis by boosting public finances through the imposition of levies and/or taxes on the private financial sector. During the lead-up to the G20 summit in June 2010, detailed international initiatives of this kind were promoted by the IMF and others. .But the G20 leaders at that summit chose not to endorse any of these international proposals. That decision had not only fiscal consequences, but also distributional ones. The same financial markets whose bailouts contributed to the expansion of public debt in Europe and the United States are now demanding government cutbacks with costs that fall on many citizens — including the most vulnerable — who played little or no role in causing the crisis of three years ago.
The G20 leaders also stepped back from regulating market instruments that are blamed by some for contributing to destabilizing speculation in the current context. Particular attention has been focused on “naked” credit default swaps (CDS), which allow investors to speculate on the likelihood of default on the underlying bond without actually owning that security. Citing the collapse of Lehman Brothers and AIG, George Soros and others have argued forcefully that naked CDS encourage self-reinforcing bear raids. Critics have asked why the G20 leaders have not yet banned these products (just as many countries prohibit the purchase of insurance where there is no underlying interest).
A more orderly restructuring of European sovereign debt could also have been facilitated if the G20 had given more attention to the task of creating an international sovereign debt restructuring mechanism (SDRM). A decade ago, the IMF’s Deputy Managing Director, Anne Krueger, described the absence of an SDRM as a “gaping hole” in the governance of international finance. She failed to convince policy makers at the time to fill that hole comprehensively, and it has remained unaddressed by the G20 leaders after 2008.
The main accomplishment of the post-crisis regulatory reforms — the strengthened capital and liquidity standards for banks under “Basel III” — will indeed create a more resilient global financial system. But these standards will not be fully implemented until 2019. Basel III also continues the tradition of encouraging private institutions to invest in sovereign debt that is rated above double-A minus, by classifying it as risk free. As firms load up on sovereign debt, contagion effects of sovereign debt crises are potentially being compounded.
The fact that regulators have continued to embed private credit ratings into prudential standards in this way also raises many questions. Credit rating agencies have hardly earned an enduring vote of confidence with their performance during the lead-up to the 2008 financial crisis. The process by which Standard and Poor’s arrived at its recent decision to downgrade US government debt did little to help its reputation.
G20 commitments to force more over-the-counter (OTC) derivatives to be traded on exchanges and cleared through central counterparties have also yet to be realized. Consequently, global financial markets are still very vulnerable to the failure of a major counterparty in the highly concentrated, globally interconnected and opaque OTC derivatives markets, just as they were in 2008.
It is striking that systemic risks emanating from this and other aspects of the poorly regulated “shadow banking system” remain a major concern for financial regulators and supervisors three years after the subprime crisis. Although the shadow banking system’s size has shrunk somewhat since 2008, it remains as large or larger than the regulated banking system in many countries today.
Last but not least, it is equally striking that authorities are still not well prepared to handle the collapse of a major financial institution operating across many countries. Credible and effective cross-border resolution regimes to wind down failing firms have yet to be agreed upon.
For all these reasons, there should be no false illusions that the post-2008 international regulatory reform process offers much greater protection against financial instability at this moment. This latest bout of market instability could well provoke a serious crisis, and its handling could well be just as ad hoc as we witnessed in 2008.
Indeed, the prospects for successful crisis management may even have diminished now. The constrained fiscal positions of leading governments leave them less room to manoeuvre than three years ago. The international cooperative spirit displayed by G20 leaders at the height of the previous crisis may also be harder to replicate today.
European leaders have become absorbed by the task of addressing the eurozone’s problems. US Congressional wrangling over the debt ceiling has also done little to inspire confidence in its current interest and capacity for global financial leadership. And strongly worded Chinese reactions to the US fiscal debate raise questions about whether China can be relied upon to play the same system stabilizing role, which it did in 2008. It was not reassuring that the G7, rather than the G20, took on the role of reassuring markets that public authorities would “take all necessary measures” to protect financial stability in early August.
If doubts grow about governments’ capacity and willingness to manage financial crises, market instability may only deepen. Declining trust in the dollar’s role as a global anchor may work in the same direction. If financial instability spilled over into major exchange rate volatility, the consequences for the world economy could well be more severe than the 2008 crisis.
Should we be feeling more secure? Hardly. Buckle up for a potentially rocky ride.
This commentary was first published in The Toronto Star.