Why More Diplomacy Won't Keep the Financial System Safe
The global financial crisis that began in 2007 marked the failure of an ambitious experiment in financial diplomacy. Since the 1970s, officials from the world's leading economies have worked together to regulate financial institutions with the aim of making the international financial system safer. When the collapse of the U.S. subprime mortgage market triggered a cascade of events that put that new international regime to the test, the results were disastrous. International agreements on the regulation of banking and securities did little to protect against a financial meltdown that severely damaged the world economy.
Inevitably, painful experience has fueled a drive to get financial regulation right. The G-20 presidents and prime ministers who met in
But that growth is not necessarily good for the global economy. Over three decades of experience have shown that international cooperation in financial regulation brings as many risks as benefits. The attempt to harmonize standards across borders has led many countries to make the same mistakes, adopting misguided rules in some areas and none at all in others. National governments have deferred important regulatory changes while waiting for multilateral agreements that may not be signed for years, if ever. Meanwhile, truly critical international issues, such as allocating responsibility for the oversight of banks operating across borders, have been addressed inadequately or not at all.
Financial diplomacy has its place, particularly when it comes to monetary policy, but on the regulatory side it is being tasked with a far heavier burden than it ought to bear. To rely on international organizations to protect the world economy against major financial disruptions is unrealistic. And expecting them to "level the playing field," the traditional justification for harmonizing financial regulation across borders, is neither reasonable nor desirable. Although international cooperation in regulating and supervising financial institutions is important, it should not be a substitute for tough regulation at the national level. Well-crafted regulations in individual countries matter far more than international accords. Most important, international agreements should not discourage a diversity of national regulatory approaches, which could make the financial system more resilient during the next worldwide crisis.
Cross-border cooperation in financial regulation came about due to two near disasters. Late one afternoon in
In late 1974, central bankers from
Bringing about international convergence on financial policy was easier said than done. Each country had its own standards for how much capital a bank needed and how that capital should be measured, and no country was eager to impose heavier costs on its own financial sector. The impasse was resolved only when the
Over time, the Basel Committee acquired numerous siblings.
Thirty-five years of negotiations over financial regulation have produced some substantial achievements. Banks uniformly have more capital than they did in the 1970s. The basic plumbing of the financial system, the channels through which securities and money change hands, is far more robust than it used to be, in large part because bank and securities regulators have collaborated to push banks to settle transactions quickly rather than letting paperwork languish for days or weeks. Supervisory "colleges" comprising regulators from several countries are beginning to oversee a handful of the largest financial institutions. Regulators now routinely collaborate on investigations of money laundering and terrorist financing. Perhaps most important of all, financial supervisors around the world know one another and see one another frequently. If there is a cross-border problem, they can readily pick up the phone and call their foreign counterparts -- although they do not always do so, as was the case in
The 1988 Basel Accord was the culmination of years of bargaining. Its provisions were relatively simple, and its flaws were widely criticized. Throughout the 1990s, the Basel Committee, gradually expanding in size, tried to fix these problems. In 1998, it began work on an entirely new agreement on the safety and soundness of banks, which was approved in 2004. Known as Basel II, this framework now forms the basis for the regulation of almost all the banks in
Conceptually, Basel II divides bank regulation into three different areas, known as pillars. The first addresses the amounts and types of capital that financial institutions are required to have, the second concerns regulatory supervision and risk management, and the third deals with using market forces to encourage bankers to behave prudently. Each pillar includes a large number of highly technical provisions that are meant to provide guidance to national banking authorities. The Basel Committee itself has no bank examiners and no enforcement power; its purpose is to encourage national regulators around the world to move in the same direction.
Unfortunately, financial regulation is far from a scientific enterprise. New regulations often respond to the last crisis rather than forestalling the next one. Some regulations prove unworkable or simply irrelevant. In some instances, the Basel Committee's attempts to harmonize the activities of national bank regulators have resulted in regulators everywhere making the same mistakes.
One such misstep was a heavy emphasis on capital levels to the exclusion of other financial concerns. Capital is critical to banks' health; it represents the resources available to repay depositors and trading partners in the event of losses. It can take several forms, such as equity (money raised when a firm issues shares), retained earnings (past profits that a firm set aside rather than using them for dividends or expansion), or loan-loss reserves (money held in expectation of future losses). Past crises, most notably the Japanese banking crisis of the early 1990s, found banks holding far too little capital to cover their losses, so Basel II told national regulators to impose higher capital requirements. Almost every country followed the same plan.
But inadequate capital is only one of the problems that can beset a financial institution during a crisis. Some institutions that seemed well positioned when the recent crisis struck suffered not from a lack of capital but from a lack of ready cash -- what bankers refer to as "liquidity." As the credit market froze up, they could not issue the short-term paper or obtain the overnight loans that they had always depended on to meet immediate cash needs. Insufficient liquidity left banks in various countries too cash-strapped to open their doors. One reason was that strong liquidity rules were virtually nonexistent, because Basel II did not mandate them.
The Basel Accords also failed the system by basing capital requirements on mistaken risk assessments.
Even less comforting, the
Finally, Basel II's emphasis on the ability of market forces to help keep banks in line proved fundamentally misguided. The agreement lays out in detail the disclosures a big bank must make about its capital position and its risks, asserting that "market discipline can contribute to a safe and sound banking environment." This premise, however, may be incorrect. Over the past year, studies have shown that the big banks that produced the best returns for shareholders in the years prior to 2007 were those hit hardest by the crisis. Because equity investors favored riskier banks, not more conservative ones, the market provided an incentive for bankers to take greater risks, not to be prudent. Nor did market discipline make credit investors wary of the bonds issued by institutions that took excessive risk and ended up in trouble. The markets bet that governments would make good on the big banks' debts, and with very few exceptions, the markets were right.
BANKERS WITHOUT BORDERS
International negotiations also failed to adequately assign responsibility for supervising those institutions whose activities cross borders. As a general rule, the lead regulator of such institutions is their home government: U.S. regulators have primary responsibility for
A more serious case, from the standpoint of systemic stability, arose with the failure of the
The banking sector is not the only area of the economy in which international financial diplomacy has failed to confront major systemic risks. It was not until
Major bond insurance companies in
In an increasingly multipolar world, such gaps in the international financial regulatory framework will become more difficult to address. The membership of the Basel Committee has grown from 12 in the 1970s to 27 today, the
THE FIRE NEXT TIME
With these shortcomings now laid bare, the various international bodies are busy refining their approaches to regulatory harmonization, and there is much talk of a possible Basel III. Proposals include requiring banks to maintain additional capital, limiting bankers' pay, supervising big transnational insurance groups, and recommending that the purveyors of subprime mortgage securities be required to hold some of those securities on their own books rather than selling them all to investors. Had all of these regulations been in force five years ago, the crisis might have been forestalled.
Yet although the last systemic crisis could have been averted, the next one might not be. No one can say with any certainty what the best rules are, and whatever rules are imposed, it is a sure bet that smart bankers and insurers will do their best to circumvent them. The closer the world comes to having a single set of rules for financial institutions, the greater the likelihood that some gap in those rules will lead to global instability. Diversity can be a source of strength.
Along with encouraging regulatory diversity, political leaders need to cultivate greater realism about what the international regulatory organizations can deliver. Realism must prevail when it comes to global governance, too: it cannot be expected to improve the stability of the global financial system. That must be the task of national governments, not multilateral committees.
There is simply no way to provide meaningful global regulation of far-flung international entities, no matter how well meaning the effort. Only national governments have the ability to establish and enforce regulations on companies operating in their territory. And only national governments can be held politically accountable for regulatory failures. This implies a step back from financial globalization in the interest of safety. Prudence dictates a much greater role for host-country regulation, with each country taking responsibility for regulating the financial institutions that operate within its borders, no matter where they are based. This is undoubtedly an inconvenient solution for the financial industry: it may force large financial companies to establish separate subsidiaries in each country in which they do business, with each subsidiary having to meet local standards concerning capital, liquidity, and risk management. Yet even if the annual costs to these companies will be higher than they are today, it is hard to imagine that they will be greater than the costs of a massive regulatory failure such as the one the world just experienced. Weak regulation can be the most expensive regulation of all.
Shifting toward greater host-country regulation will not trigger a "race to the bottom" in which business flows to companies based in countries with lax regulation. There is little evidence to suggest that the risk of a race to the bottom is real. Regulation and reputation matter hugely in finance: banks' and insurers' big customers, lenders, and trading partners care greatly about the strength of the institutions they deal with and the legal environment surrounding them. Were regulatory laxity an important competitive advantage, the giants of finance would long since have moved their key operations to places where oversight is weaker than in
The need for clear lines of responsibility should also doom the idea of an international bailout fund for the biggest banks. It would be extremely unwise to place hundreds of billions of dollars at the discretion of a multilateral committee with no direct responsibility for regulating the insured institutions. As the Icelandic saga should make clear, divorcing financial responsibility from regulatory responsibility is an invitation to supervisory neglect: if it is some international body's money that will be lost in the event of failure, and not domestic funds, no national supervisor will have the proper incentives for close oversight.
That does not mean regulators should walk away from the international bargaining table: cross-border cooperation and supervision in financial regulation are well worth pursuing. But asking international organizations to develop global standards for the financial sector will not preclude the next crisis. At some point, another crisis will come, and the precise mixture of problems that caused the last one will surely not cause the next. The best way to limit the fallout is to assign national supervisors clear responsibilities to regulate and police the financial institutions operating within their countries' borders, using a diversity of approaches. The lesson of 35 years of experience is that when it comes to financial regulation, less international diplomacy might be better than more.
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Why More Diplomacy Won't Keep the Financial System Safe
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