Recent volatility in world financial markets has reinforced the case for international financial regulatory reform. And yet at this very moment, despite all the promises and “commitments” made, the reform agenda endorsed at G20 summits since 2008 is in serious danger of stalling or even sputtering out on essential issues.
The G20 leaders must seize the opportunity of the Cannes summit to rekindle the momentum for reform. Three sets of issues are particularly urgent to address.
The first concerns the regulation and supervision of global systemically important financial institutions. The massive bailouts of 2008 provoked G20 leaders to declare at the September 2009 summit in Pittsburgh that “our prudential standards for systemically important institutions should be commensurate with the costs of their failure” (G20 Leaders, 2009: 9). But progress has been slow in cultivating international consensus on many key measures relating to this crucial initiative. Private sector resistance to tighter rules has also intensified since the last G20 summit. The G20 leaders must not let this resistance deflect them from fulfilling their commitment.
The task of developing credible, effective cross-border resolution regimes to wind down failing international firms has been particularly difficult. If meaningful international progress continues to be elusive in this difficult task, the G20 leaders should support greater use of host country regulation, forcing systemically important institutions to establish separately capitalized local subsidiaries in the various countries where they operate. Although this approach would generate some inefficiencies and costs, it would at least offer some protection against poor regulation abroad. It would also simplify the implementation of Basel III’s new counter-cyclical buffers, which are currently subject to complicated reciprocity agreements between home and host authorities.
Second, the G20 leaders must carry through on their promise to impose greater public control over the enormous over-the-counter (OTC) derivatives markets. The 2008 financial crisis starkly exposed the vulnerability of global financial markets to a failure of a major counterparty in the opaque, poorly regulated global derivatives markets. This vulnerability remains — three years after the collapse of Lehman Brothers.
The G20 leaders have previously agreed that OTC contracts should be cleared through central counterparties (CCPs) and reported to trade depositories, and that more of their trades should occur on formal trading platforms. But this G20 consensus is unravelling as different priorities emerge across financial jurisdictions.
If this situation continues, inconsistent national rules will bring on competitive deregulation pressures due to the sensitivity of these globally integrated markets to regulatory differentials. Lax regulation in one jurisdiction will generate financial upheavals that affect everyone.
In addition to reaffirming their commitment to implement existing agreements in this area, the G20 leaders need to endorse new international minimum standards for the regulation and supervision of CCPs and trade repositories, which are growing in systemic significance. Greater attention is also needed in other areas of the poorly regulated “shadow banking system,” which, in many countries, remains — three years after the 2008 crisis — as large as or larger than the regulated banking system.
To support the G20’s current effort to reduce commodity price volatility, higher international minimum standards are required for the regulation (including position limits) and supervision of commodity derivatives. In addition, the European sovereign debt crisis has boosted the case for considering a ban on certain OTC derivatives contracts that may exacerbate crises, namely “naked” credit default swaps. These products allow investors to speculate on the likelihood of default on the underlying bond without owning that security, and they have been blamed for encouraging self-reinforcing bear raids.
Third, the G20 leaders must strengthen the Financial Stability Board (FSB), the institution they created in April 2009. Despite being assigned an ambitious mandate, the FSB is severely constrained by having less than two dozen staff members, all seconded from other organizations. To fulfill the tasks that the G20 leaders have given it, the FSB needs more staff and formal legal standing. Its activities should also be more transparent to the public. In addition, the FSB should work more closely with the other international standard-setting bodies to ensure that a more integrated view of prudential issues is achieved.
The FSB suffers from a legitimacy gap caused by the conflict between its narrow membership and its ambitious goal of promoting worldwide compliance with the international financial standards it develops or endorses. Its current initiative to create regional consultative groups with non-members participating, does not go far enough — non-members remain as “rule-takers” without a formal say in FSB proceedings, while they are asked to take on many of the obligations of FSB membership. A better strategy would be to offer those countries membership in the FSB and use the regional groups to provide a formal voice in the FSB’s decision making, perhaps through a constituency system such as that used in the International Monetary Fund.
To encourage compliance with international standards, the FSB relies heavily on peer reviews, whose effectiveness is weakened by the fact that they must be approved by a consensus of the FSB’s membership, thereby allowing countries under review to veto unwanted criticism. A step towards improving compliance would be to subject the approval of peer reviews to a supermajority rule. The consequences of failing to comply are also ambiguous in the FSB Charter and need to be specified. Penalties could range from losing certain privileges, or even loss of membership in the organization, to permitting members to deny firms chartered in jurisdictions judged to be non-complying access to their financial markets..
With effective actions on these three sets of issues, the Cannes summit can regain credibility for the G20 and make progress on the unfinished business of international regulatory reform.
G20 Leaders (2009). “Leaders’ Statement The Pittsburgh Summit September 24-25, 2009.”