Tomorrow’s G20 meeting in London should not try to resolve everything. It must concentrate on what is urgent and, for the rest, start a process capable of producing a consensus on what must be corrected in the global governance of the economy and financial markets within reasonable deadlines.
As we argue in more detail in our new CEPS book, the urgent need is to halt the vicious circle of falling asset prices and mounting losses by financial organisations aggravating the credit crunch and generating more bad economic news, feeding further rounds of falling asset prices. The central issue is how to restore confidence in the banking system. To this end, it must be recognised that a continuation of the policy of “handouts without proper workouts”, notably in the US, cannot restore confidence and might lead us into a repetition of Japan’s ‘lost decade’ in the 1990s. Therefore, the deployment of government money into insolvent banks should be accompanied by a straight takeover by the state, a restructuring phase, and resale to private investors as soon as possible.
The crisis management tools available to the ECB are narrower than those of other major central banks because, unlike the Federal Reserve and the Bank of England, the ECB is not backed by a fiscal authority. A way to tackle this weakness without compromising the ECB’s independence would be to create a European Fund that would issue Eurobonds and make the proceeds available to European institutions for their financial rescue operations.
Addressing international imbalances
Once the storm subsides, the world will need new monetary arrangements that reduce the likelihood of repeating the recent instability. Financial instability has been first and foremost generated by unstable macro-financial policies in the US and by international monetary arrangements, which, since the breakdown of Bretton Woods in the early 1970s, have permitted balance of payments explosions and the unsustainable accumulation of assets and liabilities. Therefore, the first ingredient of reform should restore some shared rules of the game for international adjustment. These rules must include symmetric external discipline on domestic policies for all countries – including the US, which has dramatically abused its status as main reserve currency country – and appropriate arrangements to let exchange rates move to help correct current payment imbalances, under strengthened collective surveillance.
Managing world payment imbalances may require more than just improved coordination of national macroeconomic policies. The past two decades have been characterised by low-wage growth in advanced countries, reflecting the forces of globalisation and technical change. We deluded ourselves that the problem would be solved by investing in human capital and moving workers in advanced countries up the skill curve. In practice, this has not happened. Large layers of advanced societies have been living with declining real wages, leading to a permanently lower sustainable increase in domestic consumption.
Payment imbalances cannot be eliminated unless the real exchange rates of emerging countries in Asia appreciate substantially and domestic wages and incomes accelerate throughout the region. These countries must turn inwards and deploy their gigantic savings for housing, social welfare, and the environment. Only with substantial real appreciation of their currencies and higher growth of domestic income will there be sufficient room for more rapid wage and income growth in advanced countries.
Recognising the paramount role of macroeconomic policies does not imply that financial regulation and supervision do not need overhauling. Financial organisations have displayed a systemic tendency to over-leverage their capital and take excessive risks, pointing to fundamental distortions in incentives. In essence, there is a skewed distribution of returns from risk-taking in which large gains accrue to management and shareholders, while large losses are partly or wholly borne by public budgets and taxpayers. As rewards grew larger with rising stock markets, financial innovation was increasingly used to circumvent legal capital requirements and hide risk exposure – sometimes even from the governing bodies of the intermediaries. Excessive risk-taking was encouraged by loopholes in the global regulatory system, inadequate design of capital requirements, and the lack of transparency in financial products and risk exposure.
There are two fundamental issues in the new regulatory structure that must be decided preliminarily. First, should commercial and investment banking activities be legally separated once again, as they once were under the Glass-Steagall Act, or can we live with the system of large universal banks that now prevails in the US, following the demise of Wall Street investment banks?
Our view is that it would be sufficient to strengthen prudential rules on banks, so as to prevent them from leveraging their capital excessively and using depositors’ money to take capital market risks. The rest of the financial system should be made fully transparent in order to ensure that risks are visible and correctly assessed by investors and regulators alike. Legal separation of commercial and investment banking activities or the prohibition of particular activities is not necessary. It is sufficient to place higher capital charges on activities undertaken by banks beyond their normal banking business, such as proprietary trading and lending to highly leveraged financial organisations.
Second, should the new regulatory structure be organised by institution (e.g. for banks, insurance companies, private pools of capital) or by objectives, with separate authorities taking care of macro-prudential (systemic) stability, micro-prudential supervision, and transparency and investor protection? We favour the latter, which is also more liable to result in a rapid concentration of regulatory and supervisory powers at the EU level.
A realistic approach would be to start by centralising the organisation of regulation and supervision within large geographical areas – i.e. the US, the EU, and the Pacific – and then establishing close coordination of these macro-area regulators at global level.
In the US, the Paulson blueprint has already proposed a drastic simplification of present rules, in favour of a system of regulation by objective. The Federal Reserve would oversee long-term macro-stability for all financial entities, irrespective of their legal status, alongside a micro-prudential regulator and a conduct of business regulator.
In the EU, it is too early to aim for a single central regulator, due to the wide divergences in legal systems and administrative traditions. But is also too dangerous to keep only national authorities in charge. Karel Lannoo at CEPS and the De Larosière High Level Group have proposed a roadmap leading to the creation of a European System of Financial Supervisors, structured as the already existing European System of Central Banks. In this scheme, existing Level Three regulatory committees would be transformed in steps into two European authorities – a European Banking and Insurance Authority, in charge of prudential supervision of large cross-border organisations, and a European Securities Authority, in charge of investor protection. The ECB would be in charge of macro-prudential supervision, monitoring excessive debt build-up and asset inflation, with a clear mandate to act early to stop destabilising trends. A new Systemic Risk Council would oversee the entire construction (see Figure 1).
Figure 1. An EU system of financial regulation
A distinct merit of “regulation by objectives” is that the new European authorities could be built upon the base of existing networks of regulators without immediately calling into question national regulatory structures. Besides relinquishing legal powers for implementing regulations, member states would only be required to identify a leading regulator in charge of participating in the three EU authorities and implementing their decisions nationally.
Finally, the key ingredients of micro-prudential regulation must be decided – capital requirements, management incentives, and disclosure. As already explained, we believe that – while no financial organisation of systemic relevance should escape appropriate publicity public monitoring – there is no need to regulate every market or financial activity where there is evidence of market failures. On the contrary, a limited number of measures concentrated on banks and enhanced transparency obligations for other financial intermediaries can do the job.
Our main recipe for banking capital requirements is that the Basel II rules should be scrapped and replaced by a flat capital requirement calculated with reference to total assets, with no exemptions. The maximum permitted leverage ratio should never exceed ten. In addition, following the analysis above, special capital charges should be imposed on risky activities not belonging to normal banking business and possibly on excessive size.
Specific measures, already well identified in the public debate, should aim to strengthen risk management within financial organisations and improve transparency of information for all market participants and financial instruments. In addition, appropriate incentives can push over-the-counter instruments to migrate to organised clearing platforms, thus pooling counterparty risks and imposing de facto capital (margin) requirements on trades of structured and derivative financial instruments.
Lannoo, Karel (2008) Concrete Steps towards More Integrated Financial Oversight: The EU’s Policy Response to the Crisis, CEPS Task Force Reports
Di Noia, Carmine and Stefano Micossi with Jacopo Carmassi and Fabrizia Peirce (2009) Keep it simple: Policy Responses to the Financial Crisis, CEPS Paperbacks, March