The G20 and the Financial Regulatory Cycle
Written by Richard Reid
Date: 23rd June 2010
Summary of Dr Richard Reid's speech at the ICFR-UCL-PRMIA conference on 17th June 2010
When thinking about the regulatory response to this financial crisis, two observations from similar periods in economic history come to mind. The first is Charles Kindleberger’s comment “financial crisis – a hardy perennial”(1) : despite policy makers’ protestations that this must never be allowed to happen again, these episodes, even big ones, come around with surprising frequency. But the good news is that we do survive them. The second observation is from JK Galbraith, commenting upon the situation in the 1930s: “...regulatory bodies, like the people who comprise them, have a marked life cycle. In youth they are vigorous, aggressive, evangelistic, and even intolerant. Later they mellow, and in old age - after a matter of ten or fifteen years - they become, with some exceptions, either an arm of the industry they are regulating or senile” (2). So with these two thoughts in mind let's consider where we are in the current regulatory response to the turmoil in our financial markets.
It can be argued that there is a discernable cycle in the regulatory response to financial crises. This most recent one has its own facets, for example the initial move to share the pain by broadening the G7 to the G20. But most previous crises show a similar cycle. The first Phase, as shown in Figure 1, focuses on crisis management and stabilisation, involving key rescue packages and monetary policy measures. After this initial emergency stage we move into Phase 2 which involves the unveiling of the “grand plans”. Key elements of this phase involve high profile international efforts (in this case the G20 and the rebranding of the Financial Stability Board), and publication of influential reports (for example, Turner (3), and de LarosiŃre (4) ). This phase also sees more solid evidence that economies are stabilising, but at the same time the hunt for the blameworthy gathers pace.
Figure 1
Phase 3 sees more detailed legislative measures tabled, with some economies actually recovering, but also a ramping up of the blame game. The tensions between the aims of international cooperation and the demands of domestic agendas will start to show at this point, particularly as industry push-back on proposed legislation starts to become more apparent and effective. Phase 4 sees the hard detail of the legislative proposals become more rigorously tested and questioned. A more philosophical debate will start to surface: what do we want by way of regulation and what kind of financial system do we want? Questions concerning behaviour, ethics and culture start to surface (see, for example, the first speech of the FSA’s Hector Sants after the announcement of his future role in the Bank of England (5)). Political commitment at the international level wobbles but there is another lash of the tail with some further attempts at grand plans (for example, the IMF’s suggestions regarding financial sector taxation options, and the EU’s bank resolution plans). The economic recovery in some countries threatens to run out of steam; financial markets - and some policy-makers - begin to worry about not only the burden of fiscal consolidation but also the consequences of over-regulation.
Where are we in this cycle?
It feels like almost every month in the last couple of years has had the potential to be a critical juncture: this certainly holds true for the G20 process at present. The meeting of G20 ministers in early June highlighted differing priorities not only within the G20 but also within the G7. So ahead of the G20 summit in Toronto, where are we in the regulatory cycle?
Figure 2
Just how divided is the G20? It is clear that those G20 countries that feel they have had a “good” crisis are less willing to burden their financial systems in general, and banks in particular, with higher taxes or levies. Moreover, several emerging economies have also demonstrated a reluctance to impede the provision of credit to their economies, which have, of course, been instrumental in pulling the global economy out of the downswing. Some governments are still under pressure not only to make banks pay for failure and disruption but also be seen to be making them pay: hence the tortuous process of the financial reform package through the US Congress. In its emergency budget, the new UK government has announced the imposition of a levy on banks (from 2011) and announced that with similar moves afoot in Germany and France, the three countries look forward to discussing their proposals with their G20 partners at the Toronto summit and that they are “committed to the full implementation of the ambitious G20 financial sector reform agenda” (6) .
The regulatory response covers many aspects of financial intermediation: insurance, alternative fund management (including private equity and hedge funds), derivatives markets as well as all the “plumbing” aspects of financial intermediation, such as settlements and clearing procedures, international accounting standards and governance issues. All of these are being addressed in one way or another in a raft of industry or sector specific committees and working groups, where the practical questions have to be confronted and the realities of likely timetables accepted. Behind the political processes, the Basel Committee presses on with its reform programme, including measures on bank capital, liquidity, leverage, countercyclical buffers and systemic risk assessment.
So the current picture seems to be one in which the G20 will be able to agree a set of broad guidelines for reform, whilst allowing individual countries or regions some wiggle room to implement their own tactical measures in pursuit of the broad goals; in some cases there may be the hope that these individual initiatives become the blueprint for more widespread adoption. History suggests the public’s focus on punishing financial institutions will wane with the passage of time, although in this case, as the harsh realities of fiscal consolidation continue to bite, the lingering resentment may last longer than in previous cycles. Also, with the G20 process moving to South Korea in the second half of the year, it will be interesting to see how the priorities of developing countries are reflected in the debate. The vexed question of regime arbitrage is likely to remain, but of course it is hard to think of any period in economic history where such arbitrage has not existed.
A second element of the current situation is that of restoring confidence. In the European context this debate seems to be dominated by the need for many governments to convince financial markets that their finances are on target for a sound recovery. Of course, this also involves restoring confidence in those financial institutions, markets and instruments that are necessary for a fully functioning financial system. The need to manage risk and transform financial assets and liabilities is key in being able to provide credit to economies, deal smoothly with international capital flows and fund public sector deficits. In a way it is reminiscent of the situation described in speeches being given early in 2007 by key policy makers. The Fed’s Mr Warsh for example talked of the need to re-define liquidity - “liquidity is confidence” (7) (albeit at that time against the background of the dangers of liquidity disappearing should confidence evaporate). There is probably no single silver bullet for restoring confidence: it will require a combination of more comfort on the economic outlook, clarity about the state of our financial institutions and perhaps also more certainty with regards to the regulatory process.
This leads to a third related element of the current situation: the philosophy of regulation. What do we want by way of the regulatory response? This depends partly on who asks the question. And the answers range from greater attention to customers’ needs (both retail and wholesale), safety, avoidance of repeat episodes, growth, inclusion, efficiency and public policy. History suggests that as we move on from Phase 4, all of these considerations and others tend to be discussed more openly and, of course, the more complex the objectives, the more difficult it is to come up with simple solutions. Perhaps this is why more and more policy makers are turning to issues of behaviour, ethics and culture in the financial sector.
This leads to a final observation at this current juncture. Given Kindleberger’s and Galbraith’s comments at the beginning of this note, do we have to accept that financial crises are a necessity, bringing about a re-appraisal by policy-makers and markets about the reality of what is happening in their financial systems? Are periodic financial crises needed in order to shake the consensus which inevitably develops? Few, presumably, would positively argue for financial crises and certainly not of the disruptive type that we have been experiencing. But in the design of a new regulatory framework as much thought as possible should be put into the mechanisms which aim at effective and durable regulation, supervision and enforcement during the good times and not just during the bad times, sure in the knowledge that financial crises are very unlikely to be banished altogether.
(1) CP Kindleberger (1978): Manias, Panics and Crashes
(2) JK Galbriath (1954): The Great Crash 1929
(3) A Turner (March 2009): The Turner Review: A regulatory response to the global banking crisis
(4) J Larosiere (Feb 2009): The high level group of financial supervision in the EU
(5) H Sants (June 2010): Should regulators judge culture
(6) HM Treasury (22 June 2010): UK Budget
(7) K Warsh (March 2007): Market Liquidity: definitions and implications