Finance ministers from around the world were set to gather in Washington this weekend for the annual spring meeting of the International Monetary Fund, facing perhaps the worst global financial crisis since the Great Depression. As money-market contagion spreads, demands are growing for an international response to the inadequacies of the domestic financial regulations that experts say have fueled this calamity.
"We need an effective, integrated, and global" response, not a "segmented, partial, and national" one, Australian Prime Minister Kevin Rudd told a meeting of center-left heads of government at their annual gathering outside London in early April. And Austrian Chancellor Alfred Gusenbauer proposed creation of a "truly world finance organization" to oversee global capital markets.
It is doubtful, however, that the Bush administration agrees. The financial regulatory reforms that U.S. Treasury Secretary Henry Paulson Jr. recently proposed are domestic in nature and have drawn criticism for a lack of ambition. "Now is a time when much bigger, more-creative thinking is needed," said Harald Malmgren, a Washington-based adviser to hedge funds and sovereign wealth funds.
Given the global character of today's capital markets, experts say that any effort to sort out lines of regulatory authority and responsibility and to strengthen market supervision may fail unless it is an international endeavor. They warn that financial regulators may need to set common capital reserve requirements for financial market players and require full transparency about the nature of the financial products they sell, so that investors everywhere know what they are buying. And financial regulators may have to give up their autonomy and work together.
This won't be easy, warned Nicolas Veron, a resident scholar at Bruegel, a Brussels-based think tank. "Regulation is where the premise that all economics is now global meets the maxim that all politics is local," he said. "National sovereignty dies hard. And you shouldn't be too optimistic about what you can do at the international level. In terms of actual supervision and regulatory action to avert or control a crisis, we have no compelling examples of what can work."
The implosion of financial markets has engendered a political backlash that may have to worsen before enough political will exists to bring about serious domestic financial reform and to knit those reforms together into a set of international standards backed by effective cross-border oversight.
The recent call by Dominique Strauss-Kahn, who leads the IMF, for public funds to be used at a global level to backstop capital markets may soon bring this issue to a head. Taxpayers around the world are unlikely to be willing to have their money used to bail out banks, especially foreign ones, without tough new rules and more supervision.
Today's financial crisis is infinitely complex, the consequence of multiple failings. But the problem, many say, has its roots in financial innovations occurring for the first time in a newly globalized capital market without adequate regulatory oversight.
Over the past decade, Wall Street wizards and their creative counterparts in "The City," London's financial center, developed and sold to institutional investors, such as insurance companies and pension funds, exotic securities never before available. The desire to take debt of questionable value-such as U.S. subprime mortgages-and, by slicing and dicing it, assemble securities that were amalgams of thousands of different financial obligations drove the innovation. In so doing, investment houses argued that they were lowering the risk of any single security and thus they were able to sell the financial paper more easily. Investors accepted at face value the assurance of international rating agencies-such as Standard & Poor's-that these new financial instruments were creditworthy. Around the world, such diverse institutions as normally cautious German banks and trusting Norwegian municipal pension funds, bought the securities.
It is hardly surprising that oversight did not keep pace. Regulation in almost any field-be it pharmaceuticals or financial services-has trouble keeping up with innovation. In recent years, this inherent supervisory shortcoming helped Wall Street make the case for reliance on self-regulation and market discipline to curb any financial excesses. Moreover, the short-term economic benefits of lax supervision were so overwhelmingly alluring, both for the economy and the individuals involved, that the market conveniently ignored their potential long-term costs. The absence of many controls on international capital flows made the buying and selling of exotic financial instruments a global business. And, to maximize their profits, financial innovators engaged in regulatory legerdemain: shifting their business to lightly regulated jurisdictions throughout the world or into unregulated financial activities, such as hedge funds.
In a rising market, holders of these new securities had no trouble selling them. Buyers did not care that these bundles of financial derivatives were opaque, that it was impossible to decipher whether these slices of financial obligations were solid or in default. But in a falling market, these same securities have proved impossible to sell because they are hard to value and purchasers want to know what kind of problems they are taking on before they buy.
Until someone can answer these questions, owners will continue having trouble finding buyers for their assets and credit markets around the world will continue seizing up, not only for home mortgages but, more important, for business loans as well.
These problems highlight fundamental flaws in international financial-sector regulation, said Adam Posen, deputy director of the Peterson Institute for International Economics in Washington. "Clearly there are large parts of the financial system that have gone around the supervisors," he said, noting that some traders have set up investments in the Cayman Islands, for instance, to avoid regulation. "Their actions have had spillover effects."
The complexity of the international regulatory challenge is only going to grow as the current crisis transforms the concentration and ownership of the financial system. As American firms seek infusions of cash from foreign investors, and find many willing buyers because of the weak dollar, Posen noted, more foreign players will enter the U.S. domestic financial market, which will require new forms of international supervision.
Moreover, he argued, Basel II, the set of global financial-sector rules that just came into effect in 2008 under the Bank for International Settlements in the Swiss town of that name, is inadequate. It allows banks to assess the risk of their own portfolios-a clear conflict of interest. And rating agencies that grade the creditworthiness of securities offered to the market are paid by the very firms that benefit from a positive rating-another conflict.
The capital that financial institutions are required to keep on hand in case of emergencies is also inadequate. "Recent history suggests," wrote Nouriel Roubini, chairman of RGE Monitor, a respected financial website, "that most financial institutions were vastly undercapitalized given the kind of market, liquidity, credit, and operational risks that they were facing in an increasingly globalized financial system."
In light of the current crisis, said Katinka Barysch, deputy director of the Center for European Reform, a think tank in London, "we can look for solutions together-or we can do so separately and then spend years trying to reconcile them so as not to impede capital flows."
The Financial Stability Forum, an international group of financial-sector regulators and central bank experts under the leadership of Mario Draghi, the head of the Bank of Italy, recently floated options for joint action. It suggested that a large group of the most important international banks take some steps toward greater openness-simultaneously dis_close, for instance, their financial positions, including their exposure to mortgage-backed securities and their available capital. Another idea was to conduct "a coordinated operation to boost capital simultaneously in a number of institutions" with the help of public funds.
"The idea of a global financial sheriff is, for the time being, a bit far-fetched," Roubini wrote. But "a much stronger degree of coordination of financial regulation and supervision policies is necessary."
At the core of such coordination would be a philosophical shift away from self-regulation. "The world has learned," Malmgren said, "that the risk management systems of banks have failed and that the individuality of each bank's approach to risk management precludes comparison of one bank's position with that of another." In such an apples-and-oranges world, market discipline has broken down because investors cannot weigh the relative safety of investments.
In that environment, the first priority is the restoration of investor confidence, which requires new rules. Issuers should sell asset-backed securities in a standardized format, Malmgren said, with a detailed description of their content and the identification of the originator. If these financial products turn out to have quality and risk characteristics that are different from those advertised, investors should have recourse to the courts. "That would put a crimp in aggressive, unrestrained pursuit of earnings without concern for consequences," he said. Because virtually all securities are now sold internationally, such transparency would work only if it is required for all products in all markets, be they mortgages in London or derivatives in Tokyo.
Moreover, all financial players-including banks, hedge funds, and investment banks-should be required to keep more capital on hand. Economists will gripe that retaining such funds will slow lending and curb growth. But in the wake of what some call a "financial Katrina," the levees need to be raised, the experts say.
Furthermore, the investors, rather than the issuers of securities, should pay the rating agencies, to minimize the conflict of interest in the ratings business. And regulators should give less credence to the ratings agencies' assessments of financial offerings.
None of these basic reforms will receive universal acceptance. Standardization and transparency of securities may prove acceptable to most Europeans, who were initially wary of recent financial innovation. But enforcing those rules through the courts is an American way of ensuring compliance that may not fly with many Europeans, who are more trusting of politically accountable government agencies than they are of courts.
Negotiation of Basel II was arduous. Renegotiation of its major provisions will be, at best, a protracted exercise. Experts currently have little stomach for such an effort, but they may have little choice.
In the interim, other international initiatives may prove necessary. U.S. and European Union officials have been meeting in a financial regulatory dialogue since 2004. Participants praise the discussions, but they have yet to produce regulatory convergence.
The tortured story of trans-Atlantic attempts to harmonize accounting practices is a cautionary tale. American regulators have long had a "not invented here" mentality that has led them to question the efficacy of foreign rules. But the recent movement of financial business from New York to London in response to tighter U.S. accounting rules under the Sarbanes-Oxley law, complaints from American multinationals about the extra costs of meeting two sets of reporting requirements-one American and one global-and an increasing international awareness by the U.S. Securities and Exchange Commission finally led to an agreement late last year allowing foreign companies operating in the United States to abide by equivalent foreign accounting standards rather than American ones. The moral is, compatible international financial standards are possible. The lesson is, it takes a long time-years and decades, not weeks and months-to achieve them.
Harmonizing accounting rules worked in part because only two sets of competing standards-American and European-were involved. But harmonizing regulatory regimes in other parts of the financial sector, such as banking, in which Europeans still have national supervision, and insurance, where many American states have their own regulators, will be harder because their traditions and practices are so divergent.
Future international coordination risks being hamstrung by such competing national supervisory regimes. "The single most constructive step the Europeans could take would be to have a more consistent European regulatory framework," Veron said. "You can't do anything significant if the Europeans don't get their act together."
Similarly, on this side of the Atlantic, experts believe that Paulson's proposals to reform regulatory supervision in the U.S. are a necessary first step, even if they may prove insufficient. "You push hard for the right reforms at the domestic level," said a cautious Posen, "and keep an eye on what would be directly in conflict with things abroad."
Despite the recent flurry of interest in a coordinated global response to the financial crisis, it is doubtful that serious reforms of regulatory regimes are imminent. An international consensus on what to do is absent; experience is too sparse to demonstrate what works; and the crisis may not have hurt other sectors of the world economy enough to fuel a collective political will to act, at least not yet.
Nonetheless, a serious rethinking is in the works about how national governments should interact in managing the global financial marketplace. This will be a major theme of the G-8 meeting of world leaders in Tokyo in July. And unforeseen events-the failure of a large international bank for instance-may yet force more financial regulatory convergence across borders. Nothing focuses attention and knocks down seemingly insurmountable obstacles so much as a crisis.
This article appears in the April 12, 2008, edition of National Journal.