By Sid Verma
Wall Street's meltdown has ushered in a frenzied debate on the global regulatory response. While the US has never looked so vulnerable, the rest of the world is moving fast to gain the upper hand in sketching the new face of global finance.
Richard Fuld, the disgraced former chief executive of Lehman Brothers, chose his words carefully: “If you’re asking me ‘did the lack of regulatory framework contribute to where we are today?’ I would say yes,” the banker told an outraged US congressional panel earlier this week.
It was a staggering admission, from the ex-head of a firm that had profited so handsomely from an era of deregulation, which in turn had ushered in breakneck financial innovation, new products and trading practices, across increasingly integrated global financial markets.
More remarkable still was Fuld’s insistence that regulators knew exactly how much trouble Lehman was in during the months before its collapse.
Rep. Henry Waxman, a California Democrat who is chairing a congressional hearing into the financial disaster, said regulators “failed miserably” to prevent Lehman’s collapse and its resulting impact on the U.S. economy, which forced Congress to approve a $700 billion bailout for the financial industry.
But as the financial pandemic spreads across global markets, dragging down both bank and non-bank financial institutions and threatening economic output worldwide, calls for enhanced financial supervision are growing louder by the day.
Global discontent
The US financial meltdown has also emboldened critics of the Anglo-American laissez- faire model. Politicians, regulators and market players globally are now seeking greater oversight of the US system. They argue Wall Street has exported risky financial products, and, in doing so, held global financial markets under siege by US free-market fundamentalism.
The global discontent has not gone unnoticed by US regulators. “We are now seeing the international community of regulators trying to come to some consensus with the US for greater regulatory co-operation because so far we have been exporting our problems to different countries,” says Mary Schapiro, chief executive of the Financial Industry Regulatory Authority (FINRA), the US regulator for publicly traded securities.
French President Nicolas Sarkozy, famed for his pro-American economic liberal bias, said in a speech to the United Nations last month:“Let us rebuild together a regulated capitalism in which whole swathes of financial activity are not left to the sole judgment of market operators.”
German finance minister Peer Steinbruck in September slammed the US argument that markets should remain free as possible from regulation in order to promote innovation as being “as simplistic as it was dangerous”.
The “weak, divided financial oversight” of US investment banks is to blame for the crisis he claimed, blaming Washington for failing to heed Germany’s calls for greater regulation when Berlin chaired the G8 last year. These proposals “elicited mockery at best or were seen as a typical example of Germans’ penchant for over-regulation,” he noted.
European policy-makers are now lobbying for the euro zone to take a larger role in international regulatory politics, as a buffer against perceived US regulatory laxity.
What’s more, in this period of heightened international financial diplomacy, the US has never looked so vulnerable. Washington depends on massive inflows of foreign capital to fund its deficit, to the tune of roughly $3 billion a day, and this is set to increase as the Treasury steps up public borrowing to fund its plan to rescue toxic assets on bank balance sheets. US authorities must rely now more than ever on co-operation with other markets.
In addition, the US has called on sovereign wealth funds to submit to internationally agreed standards in a bid to improve market transparency given their $3 trillion worth of assets. Yet, by contrast, the US failure to regulate the $62 trillion credit default swaps market, which many argue created the dangerous leverage and ruinous counterparty risks that has induced systemic failures, has weakened Washington’s international leverage.
“The US has lost moral authority and now the international community has a lot of leverage,” says Claudio Loser, a former IMF official.
Epic failure
The global credit crisis represents a regulatory failure of monumental proportions, says former US Securities and Exchange Commission chairman David Ruder, now a law professor at Northwestern University.
“It is eminently difficult to understand how these complicated instruments could be created when the investment banks, commercial banks, the Fed, the US Treasury, the credit rating agencies, the creators of the instruments and the SEC failed to understand the risks,” he tells Emerging Markets. “This has been a systemic failure on an epic level.”
A year ago, as the crisis in the US leveraged loan industry exploded, moves for greater oversight of the structured finance industry and credit rating agencies quickly gathered pace. But moves to minimize the liquidity, credit and operational risks faced by banks under the Basel II accord, has focused on risk-taking by individual firms, rather than a systemic overhaul of financial markets.
A consensus is now emerging that centralized national regulatory regimes and effective global co-ordination is urgently needed, given the complex interplay between different parties involved in crisis management – collective action by solvent banks, central bank liquidity, regulators, deposit insurance and fiscal authorities.
“This crisis has shown that all the world’s markets are intimately inter-linked and so supervision on the national level needs to be rationalized and consolidated,” former SEC chief Harvey Pitt tells Emerging Markets. “More importantly, I have no doubt that we now need to find a way of regulating on the global level.”
Changing philosophy
Nevertheless, a sea change is taking place in US regulatory philosophy that could assuage some of its critics. There now seems to be a shift away from the “market self-discipline” philosophy that has fed policy-makers’ refusal to meaningfully supervise the financial industry and the derivatives industry, in particular, explains FINRA’s Schapiro.
This conviction placed a premium on principles rather than prescriptive rules to ensure financial innovation and profitability. Financial reform proposals in US as well as Europe include nationalizing credit rating agencies, registering large-scale loans, mandating minimum standards for complex debt securities, stricter risk exposure disclosure rules for hedge funds and possibly capital requirements for leveraged institutions.
Such moves are aimed at preventing institutions taking highly leveraged pro-cyclical investment gambles and to enforce a degree of risk management on banks as well as non-bank financial institutions.
But market participants will always work around curbs on certain practices, says Peter Wallison, fellow at the American Enterprise Institute (AEI) and key architect of financial market deregulation under the Reagan administration.
Just as capital requirements triggered institutions to shift their activities into off-balance sheet instruments or through less regulated non-bank financial institutions, restrictive rules in one jurisdiction will force market players to flee to less regulated shores, he says.
“If US regulators impose restrictive measures, the Dubais and Singapores of this world will just open up their markets and US players will find a way to work with them. In other words, things will go on as usual,” says Wallison.
Universal framework
To curb the risk of such regulatory arbitrage, there are growing calls for a uniform supervisory framework to oversee complex securities and the operations of non-bank financial institutions. This could potentially address regulatory capital, type of supervision, liquidity ratios, disclosure standards and systemic risk.
Former IMF chief Michel Camdessus, for instance, has urged international regulatory co-operation under the auspices of the IMF.
“You need a central authority for supervision, for proposing measures and checking their implementation,” he said. The IMF would be “perfectly positioned” to assume a wider regulatory role, but “you can find other institutions if you don’t like the IMF,” he added, acknowledging the political difficulties in beefing up the powers of the policy lender.
IMF chief Dominique Strauss-Kahn has also been calling for a new system of market regulation, in a bid to turn the Fund into a global enforcer of financial standards. “We can have national or regional authorities, such as the European Union for example, but we need a global guarantor, an institution which monitors standards,” he said this month. The IMF, he continued, is “ready to do what is required if we are given the mandate.” In the absence of such a system, and if national governments continue to bail out failing banks, “it will give the idea of bottomless pits ... that the state will come to the rescue of incompetent managers and greedy speculators.”
Support for increasing the IMF’s regulatory powers has already been advanced by one powerful IMF governor- the British Chancellor of the Exchequer Alistair Darling. In April, he argued the IMF should work with Financial Stability Forum (FSF) – a grouping of major finance ministers, central bank governors, and banking authorities under the auspices of Bank for International Settlements (BIS) - to develop an early-warning system and multilateral surveillance.
Loser suggests that Financial Sector Assessment Program (FSAP) - the IMF/World Bank’s surveillance project of member states’ activities – is a mechanism well positioned to provide stringent regulatory oversight. He urges member states to beef up the FSAP’s executive power to critically assess and mandate securities regulation for controversial products.
This mechanism was set up in the wake of the 1997 Asian crisis but the US only this year reluctantly gave the green light for an assessment of its financial system, with a report due in 2009.
Thanks, but no thanks
But former SEC head William H. Donaldson argues that “the idea of such a global regulatory sheriff is nice in theory but there is no political will.”
“Instead, we will see a top down and bottom up approach with national regulators maintaining absolute sovereignty over their financial jurisdictions but increasing co-operation in terms of disclosing and explaining their financial market activities,” he tells Emerging Markets.
Loser warns this type of engagement risks replicating the failures of the FSF as simply a talking shop. “We don’t want a series of meetings every six months where authorities just read a pre-prepared speech and go on with business as usual. There needs to be historic multilateralism.”
He adds: “There is an absolute need for landmark international co-ordination in the same way the Bretton Woods institutions were set up after WWII. Now the US, UK, Eurozone, the Bric countries need to come together.”
“Any regulatory re-ordering of the US financial market must be intimately related to corresponding global efforts,” Arthur Levitt, chairman of the SEC between 1993 and 2001, tells Emerging Markets.
His successor, Harvey Pitt cites the 2001 agreement to adopt common accounting standards known as the International Financial Reporting Standards (IFRS) for domestic, listed companies in 85 countries.
In 2008, the IFRS achieved convergence with the US Financial Accounting Standards Board. “These agreements have set a precedent for international collaboration that we can now learn from,” he tells Emerging Markets.
Over the last eighteen months, the SEC has signed several cooperation agreements with various international regulators including China and Germany. “We can use various protocols agreed at the international level that national regulators can follow,” Pitt adds.
End of the road
But meaningful multilateral action remains unlikely. Bimal Jalan, former governor of the Reserve Bank of India. “Although we may need a global framework, it is not going to happen as countries now want to go their own way, including developing economies.”
One effect of global turmoil might be increased regional monetary and financial co-ordination. East Asian nations, for example,t have been agitating to project their newfound economic might on the global stage: at the ASEAN + 3 meetings in May, which saw an agreement on a multilateral currency-swap scheme, Japan proposed the creation of an Asian version of the Financial Stability Forum.
But greater regional co-ordination in such developing regions is not a really an attempt to address regulatory laxity or achieve convergence on securities trading due to the differences or immaturity of local capital markets, says Wallison at the AEI. Instead, the goal is to boost developing countries’ leverage on the international stage, where regulation is used as a proxy weapon to challenge US dominance.
Wallison says: “the US is under pressure from the rest of the world and it will not and should not submit to foreign regulation or given any body executive power to oversee internationally traded securities or the activities of banks”.
Meanwhile, there are growing fears that after international parties come together in their show of solidarity, momentum for global co-ordination will be lost. Worse still, there may be a backlash against the idea. “Policy-markers are going to be looking at their own domestic problems but the urgency of having regulatory co-ordination internationally is so compelling that we need to avoid factionalism,” urges Levitt.
Says Loser: “I fear that in the face of critics and more supervision in various regions of the world, the US will respond with even more isolation and nationalism.”