The winds of change are blowing in London as the G20 prepares to meet. Unfortunately no one knows when the winds will stop and who will be swept away. There are many views, however, on how and where to take cover. Many countries, particularly the European countries, are agitating for agreement on global and coordinated regulatory measures to improve both the macro and micro prudential regulation of banks, other financial institutions and capital markets in general. Other countries, particularly the United States, are more focused on the imperatives of a global and coordinated approach to stimulus to revive a rapidly deteriorating economy. Others countries like China, India, Brazil and Russia come to London with complex and different problems but united in their insistence on gaining a more vocal and powerful place in the governance of the international financial system. China, in particular, is voicing concern about financial mismanagement, massive debt loads that countries like the United States and the UK are assuming and a status quo that leaves one of the largest and still growing economies on the periphery of global financial management. The G20 will have to attempt to reconcile these competing views and strategies and work toward some meaningful consensus on how to address the myriad of problems that confront the present and future of the financial system. But can the G20 possibly arrive at some consensus and strategy for a global approach to financial system management? And perhaps, more importantly, is that where the international community should be focusing its efforts?
These are not, of course, new debates. There have been numerous crises that have inspired international discussions and initiatives that have led to a nascent regulatory framework, at least for select financial institutions. While Bretton Woods was the first meaningful international effort at financial system coordination and led to the creation of the World Bank and the IMF, the international community has developed a much more elaborate global financial architecture since then. There are institutions, agencies and informal networks many of which attempt to share information, promote improved policies, and identify problems that could compromise the health of individual state systems or global capital markets. In some cases these initiatives are state-centred while, in other cases, industry associations have led efforts at cooperation, financial management and information sharing. The Financial Stability Forum, the G20 and Finance Ministers Forums, the World Bank and IMF and the Basel Frameworks I and II represent the diverse institutional avenues for financial management at the international level.
While various financial governance institutions and agreements exist, they collectively and individually have lacked the ability to identify and manage risks in the financial system. Even if there are forums for discussion and information exchange, or basic non-binding agreements dealing with issues such as capital adequacy such as Basel II, these current approaches and institutions can easily be found wanting, particularly given the evidence of their failure to warn about the storm clouds in the world of finance that collected over many years. Furthermore, even if these institutions were prescient enough to see some of the problems before they happened, they appear not to have had the political will and institutional clout to ensure that there was a meaningful audience for and response to their warnings.
As many countries coming to the G20 observe, the current financial crisis provides an unusual opportunity and credible argument for reforming these inadequacies of global finance, its institutions and the way we collectively analyse and respond to risk. While there is little consensus on what form a new global financial regulatory architecture should have, there is a significant list of perceived problems and gaps in the current architecture that many governments want to correct. These problems range from the absence of coordinated macro and micro prudential oversight for banking institutions, absence of regulation for non-bank financial institutions (shadow-banking), the excesses of executive compensation, lack of disclosure and transparency about assets, uncoordinated and misleading accounting practices that fail to capture asset values, and financial products like derivatives that do not trade transparently through an exchange or clearinghouse.
These gaps and flaws in governance arguably all contributed to the current financial crisis. More information and evidence is needed to know exactly how and why, but there are already good arguments to suggest that there are many features of our current financial system that can and should be improved. Regardless of what the evidence reveals, or how equivocal it is, there is also a palpable crisis of confidence in the financial system. The crisis in confidence permeates the system: from those who work within the system and from those who look at it from the outside. From the inside, intrabank lending still remains weak, credit is difficult to get even for good businesses and promising financial transactions, counterparties are suspicious of each other, assets values on bank books remain unknown or dubious, and major institutional investors are remaining on the sideline awaiting how all these issues play out. From the outside, confidence and perception are also working against the financial system and the markets. Consumers and taxpayers are angry that the crisis occurred, despair as their investments, pensions, home values and jobs evaporate, and are quick to blame any or all of the possible culprits. The strange and stark reality is that no one knows exactly what happened and which of the many potential causes was to blame, or which combination of things: risky financial instruments such as CDOs, hedge funds, naked short selling, mark to market accounting and the list goes on. But whoever and whatever is to blame, there is a desire among many to reconstruct a financial system that is more reliable and resilient than the current one. While there are still market players and beneficiaries that merely want to return to the good times of profits, growth and unbridled financial entrepreneurialism, others want to ensure that the system is sustainable, robust and has the integrity to withstand the numerous challenges that lie ahead in the future of global capitalism.
This type of systemic change will not be easy to achieve. It requires more sophisticated techniques for risk management at both the firm and governmental level. It requires many possible regulatory reforms including new regulation, more intelligent old regulation, and the courage and insight to not regulate when regulation is more likely to be counterproductive than beneficial. And perhaps most difficultly, change to the financial system requires some form of institutionalized global cooperation. Capital markets are increasingly global and complex and beyond the reach of any one state or regulator. The days of one country- including the United States- being able to set the rules and standards for financial conduct, are disappearing if not gone. While national regulation will continue to set out rules that many others beyond its borders will follow, national regulation will become less influential if only due to the increasing number of financial players like China and India that will create their own rules.
There are signs of an informal coalition of states who will advocate strongly for change at the national and global level. There are already many proposals advocating for coordinated supervision of financial institutions, improved information sharing, and new or improved regulatory frameworks for financial institutions that currently operate outside of most regulators’ view. Hedge funds, credit rating agencies and derivatives markets feature prominently on the agenda of many states, particularly EU states like France and Germany. Beyond these “easy” targets, there will be mention of excessive leverage of banks and particularly shadow-banks and the need to regulate or supervise capital adequacy beyond agreements already reach through Basel I and II.
While many of the proposals that G20 countries have promoted leading up to this week’s meeting outline useful change to the international financial architecture, it is reasonable to be skeptical about the sincerity of the reforms being proposed. Though it may come as a surprise to even the most cynical of political observers, the G20 has often been more about posing and posturing for domestic audiences than it has been about meaningful policy reform. Coordinated change at the global level is difficult and carries consequences for the independence of nation states and their financial sovereignty that many states are unwilling to accept.
There is also reason to be skeptical of the feasibility of global financial reform. Collective action at the global level is particularly challenging. It not only carries the burden of evidence to illustrate that the proposed reforms would work, it also carries the burden of creating the resources to make it work. And extra resources are in short supply at the moment. Our experience with global coordination on international issues has indeed not been a happy one. The looming environmental catastrophe of climate change with all its social, economic and political consequences has still not been enough to catalyse a powerful and proactive international response. If the international community has not been able to coalesce around the climate change story, it is much less likely that the arcane and complex world of derivatives, leverage and global capital markets will capture and sustain our attention.
And there is yet more to consider and weigh. Even if circumstances have given birth to new opportunities for change that previously seemed impossible, there is good reason to be cautious and deliberate about the change that is pursued. There are no simple or immediate answers about how regulation of finance should be used and how global decision-making for global capital markets should be institutionalized. Prudence and perspective are useful in the discipline of regulatory reform but both may prove to be a luxury that the urgency of the moment does not accommodate. As a result, prudence and perspective may need to guide rather than dictate whether useful action can be achieved now or whether any change must wait until later. That is to say that choices may need to be made about which changes can proceed immediately guided by useful information and good policy, which proposed changes require more information and study, and which changes are just not politically or otherwise feasible even if there is strong argument for change.
Amidst these competing concerns and instincts, there is an urgency for reforming global finance, its excesses and the way it serves the global community. The crisis has created an opportunity that may soon evaporate as banks and market players regroup and regain their clout, coherence and the confidence of market actors. Confidence may return to markets and its participants not because of change in the financial marketplace but rather because of our desire and ability to prefer the comfort of the status quo to the potentially turbulent world of reform. Making these reforms even more difficult is the complex psychology that rules markets including our remarkable collective ability to forget the problems of the past when markets are improving or booming. Our focus quickly migrates from despair to hope stoked by the opiates of growing stock values, pensions, home values and the irrational exuberance of the day.
While proponents of global action face formidable challenges, not everything remains in favour of stasis and against reform. For those who oppose change and prefer the comforts of the status quo and its privileges, they will have to swim against the tide of public outrage and the desire for more scrutiny of the world of finance, banking and all of its excesses. Whether for good reasons or bad, the ways of the past, the status quo, the “normal”, may not reappear, not in the short-term and perhaps not in the longer term either. The financial system may have to reinvent itself and prove itself anew to be able to deliver on its promise of meaningful wealth generation and growth. It may also have to prove that the wealth generation and growth pursued through markets is for the benefit of all and not just some. The promise of the market cannot just be a theoretical concept. It must resonate in theory and in fact for more people around the world and over a longer period of time. Financial markets and practitioners cannot rely on asset bubbles to generate wealth and interest: particularly when these bubble events are growing in severity and number and always end rather badly. The financial system cannot survive on bubbles that eventually bust leaving only a privileged few to benefit along the way. Whether global action and regulatory oversight will be the new zeitgeist for our financial future is unknown. But our opportunity to make real choices about our future and its principles is more possible now than it has been in a very long time. Hopefully neither the geists, the shadows in the closet or the formidable nature of the task will make us recoil to the comfort of the status quo.
By Robert Adamson, Executive Director, CIBC Centre for Corporate Governance and Risk Management, Segal Graduate Business School, Simon Fraser University, Vancouver CANADA
April 1, 2009