What is the future of

international finance?

John EatwellCentre for Financial Analysis and Policy

Judge Business School, Cambridge

Financial Stability Forum

Endorsed by G7 Finance Ministers, April 2008

“A striking aspect of the turmoil has been the extent of risk management weaknesses and failings at regulated and sophisticated firms”

Alan Greenspan

“The modern risk-management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year.”

23rd October 2008

Mervyn King

“Financial markets are global. Financial rescues are national”

40% of the $120 billion dollars the US taxpayer provided to save AIG was paid to non-US creditors.

Bretton Woods System1944-1971

• capital controls

• fixed exchange rates

• public sector carried forex risk

The end of Bretton Woods

• On 15th August 1971 the world of international finance was changed forever. Richard Nixon “closed the gold window”. The dollar floated and forex risk was privatised.

International financial liberalisation

• The ratio of forex trading to international trade in goods and services plus long term investment rose from 2:1 to 80:1 today

• Overseas sales of US bonds rose from 3% of US GDP in 1970 to 150% in the mid-1990s. Overseas sales of UK bonds rose from nil in 1970 to 1000% of UK GDP in the mid-1990s.

• The stock of assets traded in global markets exceeds 3 times OECD GDP

The reaction to Liberalisation

• 1974 Herstatt Bank and Franklin National Bank: establishment of the Basel Committees by Group of Ten. Basel Concordat.

• 1982 Banco Ambrosiano: adequate supervision• 1988 Basel One 8% capital requirements• 1991 BCCI requirements for consolidated supervision• 1992 VaR analysis of regulatory capital• 1994 Mexican crisis: G7 urges IFIs to take action• 1997-8. Asian and Russian crises: Financial Stability Forum

set up (1999); IMF and World Bank enhance regulatory roles• 2008 Basel Two and the Capital Requirements Directive

Basel 2

Consider the three pillars of Basel 2:

Pillar 1 - the determination of regulatory capital now heavily weighted toward use of banks’ internal risk weighting models, as well as the views of ratings agencies;

Pillar 2 – supervision;

Pillar 3 – market discipline enforced by greater disclosure of banks’ financial status as well as their internal risk management procedures.

A market based approach

• Models reflect firms’ analysis of market conditions.

• Market sensitivity increased by Pillar 3.

• Pro-cyclical.

• Most important of all takes no account at all of the externality of systemic risk

Risk

• Credit risk

• Systemic risk – an externality– the bank-run

• Liquidity risk

Liquidity as adjective

• Liquid markets

• Liquidity premia

Liquidity as noun

• Excess liquidity.• Markets awash with liquidity.

• Liquidity is “the ability of agents to command purchasing power by acquiring liquid liabilities, an ability dependent on the willingness of others to provide purchasing power against the issuance of liabilities”.

Major UK banks’ customer funding gap,(a) household saving ratio and foreign interbank deposits(b)

Sources: Bank of England, Dealogic, ONS, published accounts and Bank calculations.

(a) Customer funding gap is customer lending less customer funding, where customer refers to all non-bank borrowers and depositors.(b) Data exclude Nationwide.(c) UK household savings as a percentage of post-tax income.

The Response

• from the FSF and from the G7 Finance ministers:– more transparency– more disclosure– more effective risk management by firms.

• More of the Same: “The New Basel Consensus”

Analysis

• An excessive reliance on markets to deliver systemic stability!

• Far reaching re-appraisal of the analysis underpinning financial policy is required

Message from the G20

• Urgent re-appraisal of the underlying philosophy of risk management – “more transparency, and greater market exposure” may do more harm than good

• Emphasis on systemic risks to be a fundamental component of all supervisory activity

Macro-prudential regulation

• First, regulators must introduce stress testing for the system as a whole. – the regulator should conduct system-wide stress tests of

those scenarios most likely to produce systemic stress – such as a 40 per cent drop in house prices.

– the information gleaned in this exercise should feed into regulatory measures that are likely to be quite different from those suggested by the risk management of an individual firm

Macro-prudential regulation

• Second, financial institutions must be required to undertake pro-cyclical provisioning, raising their capital reserves in good times and using those reserves as a cushion in bad times.– note that this is use of capital as a buffer, not a charge

– the provisioning requirements should be based on the health of the economy as a whole, so capturing systemic strength and weakness

Macro-prudential regulation

• Third, high leverage should attract high capital charges. In addition, it may be necessary to impose limits on leverage (leverage collars) if capital charges alone are not sufficient to limit leverage expansion in an upswing.– serious mismatches between liabilities and assets have

exposed firms to liquidity risk.

– a distinction should be drawn between short-term funded leverage and longer-term funding.

Macro-prudential regulation

• Fourth, detailed supervision of firms’ business models should be conducted within a context of macro-risk assessment. – the second pillar of Basel Two, “enhanced

supervision”, is firm-specific. As the failings of the Basel approach have become clear, more and more has been piled on this pillar.

– if business models are related to macro-prudential goals, supervision may play a part in reinforcing regulatory strictures.

Macro-prudential regulation

• Fifth, there should be a return to the separation of “utility banking” from the “casino banking” of the investment banks. – this proposal, popular with some and deemed

impossible by others, seeks to break the dangerous chains of counterparty relationships in the disintermediated financial system.

– if commercial banks had no access, or very limited access, to wholesale funding and the markets for securitised instruments, they would have to source their funding from their depositor base.

– this could not be achieved in one country.

Macro-prudential regulation

• Sixth, there should be strict regulation of non-tradable financial instruments, encouraging instead the issue of standardised instruments, readily susceptible to clearing.– The problem is not transparency, but complexity.– Limiting the issuance of complex, customised, often

non-tradable instruments would reduce the risk of the massive write-downs seen over the past 12 months, and provide a ready flow of information on market stress.

– “Glass-Steagall lite”.

Macro-prudential regulation

• Seventh, to secure effective macro-risk management financial regulation must escape from its present focus on the nature of institutions – commercial banks are regulated differently from investment banks, hedge funds are not regulated at all – and concentrate instead on function.– Targeting regulation on highly leveraged financial

institutions, whatever their formal legal status, would be an important step.

The international dimension

• The biggest challenge to the new macro-prudential framework derives from its “macro” character. In a world of open financial markets the macro-economy is the global economy.

• The risks taken in one jurisdiction may well have macro consequences in other jurisdictions, and, conversely, macro-economic financial events abroad may well impinge on firms at home.

• This takes the international dimension of regulation far beyond the issues faced in the past 35 years.

The micro factors in international regulation

• First, with respect to firms that operate in more than one jurisdiction, once agreement has been reached via the Basel committees on the home-host issue, then the regulatory domain becomes essentially national.

• Second, the international dimension of the regulatory process takes the form of principles and standards that can be adapted to national legislation.

• Third, the micro concerns of the regulators do not impinge directly on other aspects of national economic policy. Such impact as there may be is confined to regulatory arbitrage (encouraging the growth of financial services by “lighter” regulation) and tax avoidance.

The macro factors in international regulation

• First, in a regime of liberalised international financial markets, macroeconomic factors are necessarily international.

• Second, it will be necessary to capture macro-economic externalities by means of common rules, since a seamless market will require common actions irrespective of juridical boundaries.

• Third, macro-prudential measures will impinge directly on other aspects of national policy, whether monetary policy, credit, housing and other asset markets, corporate structure, and so on. Moreover, the management of seemingly micro-risks, such as currency mismatches, might be better managed by macro-measures, such as capital controls.

Institutions

• An ideal type might be the World Financial Authority (Eatwell and Taylor, 2000).

• But whilst the concept provides a useful template against which to test existing institutional structures, there is clearly no appetite at present for the creation of such a potentially intrusive organisation

Institutions – the FSF

• As the major international financial “think tank” the FSF would be a logical location for the development of the new rules.

• It has the right sort of membership – gathering together regulators, central banks, and treasury departments – and it could form a macro-prudential counterpart to the Basel committees.

• Its major weakness, is same as the major weakness of the Basel committees. It is a consensual, soft law, organisation, not well designed for surveillance and the propagation of rules.

Institutions – the IMF

• The IMF is a treaty organisation, with powers in its articles of association to conduct macroeconomic surveillance, and it has taken steps in recent years toward a role in international financial regulation.

• However, the IMF’s powers have in recent years typically been used with respect to developing countries, where its approach has, to say the least, been controversial.

• The IMF has not been effective in dealing with the major advanced economies that might be deemed financially systemically relevant.

Institutions – post G20• The FSF is to be transformed into a Financial

Stability Board, with responsibility for policy development and a joint surveillance role with the IMF.

• This is probably the best structure possible in current circumstances.

• The Financial Stability Board will be “piggy-backing” on the treaty powers of the IMF, whilst serving a smaller constituency, and hopefully retaining some “soft-law” flexibility. If successful, it should become the identifiably dominant international financial regulator.

What is the future of international financial markets?

• Either there will be a fundamental reform, or very little will be done.

• Fundamental reform must mean new international rules and effective institutions to carry them out – this is even more radical than the Bretton Woods agreement in 1944.

• Muddling through will result in increasing financial nationalism

Financial Supervision and Crisis Management in the EU

. Kern Alexander

John Eatwell

Avinash Persaud

Robert Reoch

www.europarl.europa.eu/activities/committees/studies/download.do?file=19191#search=%20Financial%20supervision%20