JOB/SERV/38
18 February 2011
Committee on Trade in Financial Services
COMMUNICATION FROM BARBADOS
Unintended Consequences of Remedial Measures taken to correct the Global Financial Crisis:
Possible Implications for WTO Compliance
The following communication, dated 16 February 2011, from the delegation of Barbados is
being circulated to the Committee on Trade in Financial Services (CTFS).
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1.
There are many lessons of the global financial crisis which it is imperative that governments
and regulators take cognizance of, many of which flow from their attempts to deal with the crisis.
Among these is the prospect that remedial action taken may be in contravention of international
agreements, conventions and commitments given under WTO GATS. Also, it is essential that
measures used to mitigate the effects of the crisis do not contain the seeds of future problems.
2.
While most rescue packages have helped to encourage the return of stability to the system,
principally by facilitating the opening of the credit markets in the short term, it is important to ensure
that measures which are part of rescue programmes do not have unintended adverse consequences
over the medium term, create moral hazard or encourage cross-border protectionist actions.
3.
In addition, the crisis has served to highlight flaws in the global regulatory and compliance
environment which hamper the implementation of corrective measures and in some cases make them
open to challenge. Unless it is assumed that such problems will never again recur, they point to a
need to review some aspects of the global rules including WTO GATS rules within which countries
operate, so as to permit remedial measures to be implemented without running the risk of having them
viewed as contraventions of commitments. The first part of the paper will examine those measures
that contravene or could potentially contravene commitments given under the WTO and the GATS,
and the related Understanding on Commitments in Financial Services (referred hereafter as "the
Understanding"), while the second part of the paper deals with the medium term consequences of
remedial measures from a regulatory and financial stability perspective.
Section 1
4.
Many countries have introduced a number of new regulatory measures governing banks and
investment houses in an effort to protect depositors and investors. Many of these remedial measures
may well be in contravention of the standstill provisions contained in the Understanding in the case of
those countries which have agreed to such commitments. For example, many banks and investment
banks routinely engaged in high risk operations prior to the financial crisis and in some cases engage
in short-selling on a significant scale. One remedial measure put in place in the aftermath of the crisis
was the banning of naked short selling - a measure put in place in May 2010 by a European country
regulator, when it enacted a ban of naked short-selling of credit default swaps on eurozone
government bonds. This intention was subsequently repeated in the Annex to the G20 report of the
Seoul Meeting of November 2010. However, under the Understanding, a Member may not ban a
highly risky financial service in banking, insurance or other financial sector if it has given
commitments under the Understanding. 1
1
11-0856
See Section A –"Standstill" of the Understanding on Commitments in Financial Services.
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5.
The new financial regulatory reform bill passed in one country in North America in May 2010
includes a provision that would force some of the biggest banks to spin off their trading in swaps into
special subsidiaries or be denied access to the federal emergency lending window. There is also a
strong initiative led by a well known financial expert, to make credit default swaps available only to
people who own the underlying debt. However, under the Understanding, Members which have given
these commitments are reneging on them if they impose limits on the types of financial services
which an entity may provide.2
6.
Issues such as large size of mega financial institutions and adequate capitalization in the
financial industry need to be addressed as a matter of urgency in view of the possible medium term
outcomes. While these matters have been flagged, actual corrective measures have been deferred or
are scheduled for future implementation. So far the increased capitalization criteria agreed in
principle by the Financial Stability Board in July 2010, approved by Bank Supervisors in
September 2010 and applicable from 2011 apply across the board to all institutions irrespective of
size. New capital criteria for large banks have been deferred, but are intended for introduction at a
later date. The proposed limitations may very well be in contravention of the Understanding should
banks argue that this adversely affects their ability to compete.3
7.
The issue of who supplies lender of last resort facilities to the non banks and insurance
companies in a normalized environment needs to be addressed. Financial institutions not regulated at
the time by eventual rescuers were bailed out by either the government or the monetary authority. It
is accepted that official intervention was necessary at the time, since the problem was severe.
However, this must be seen as a one-off development as it has the potential for compromising
regulatory autonomy. There is too, the related matter of the implications of risk-taking if financial
institutions begin to expect to be bailed out in difficult situations and the moral hazard consequences
for the essential quality of due care - where there is expectation of a back-stop. Takeover of financial
institutions by government was never anticipated under the GATS by countries which had committed
those sectors. Yet this has occurred in several jurisdictions who are signatories to the GATS. Indeed,
the involvement of Government as providers of liquidity to these institutions cannot be a legitimate
option as lender of last resort over the long term, where government is also the equity holder. It is
important to guard against conflict of interest situations, where governments take equity positions in
financial institutions which they bail out. This may well be in contravention of the spirit if not the
letter of the GATS, which leans toward defining public financial entities as those which are not
providing commercial services to the public.
8.
Perverse incentive systems have been the one cause of the crisis which received the most
public attention. At the root of this was whether finance specialists should be compensated in ways
which relate to unrealized returns to the organization. It is generally agreed now that incentive
systems needed to be reviewed and modified in such a way that compensation reflected the risk
assumed by the firm at initiation and that income and prospective returns are not converted into
compensation benefits merely because bad credits have been securitized and sold before their
operational soundness could be established. Indeed, some members have agreed to the capping of
banks bonus payments. However, the regulating of salaries and incomes in these sectors could be in
contravention of the spirit of the GATS for those countries which have given commitments not to
limit the benefits enjoyed by financial service suppliers.4
9.
Consideration may need to be given also to having a mandatory specified time frame during
which risks must be retained by the initiating institution before they are passed on through innovative
securitized techniques. Efforts are now being made to review overall risk assessment techniques and
2
Par B.7 of the Understanding on Commitments in Financial Services.
Par B.10.(d) of the Understanding Commitments in Financial Services.
4
Paragraph B.11 of the Understanding.
3
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prevent financial institutions from placing poor risks on the books of other unsuspecting investors. It
is also generally acknowledged that hedge funds are highly risky activities. Indeed, in some
jurisdictions regulators have been giving consideration to banning the use of hedge funds. However,
some countries have already made commitments under paragraphs B.7 and B.10(d) of the
Understanding and might find the imposition of restrictions controversial even though they apply to
resident companies as well.
10.
The role and the prominence given to risk mitigation techniques needs also to be examined.
In this regard, there is a view that there needs to be stricter guidelines for risk mitigators and greater
analysis of the role and criteria used in offering credit default insurance as well as stricter supervision
of credit default swaps. It may be necessary to impose conditions on risk mitigation techniques so as
to limit the level of risk assumed by financial institutions. In addition, where these high risk
instruments have not yet been offered, it may be prudent to prevent financial institutions from offering
new instruments of which regulators do not approve. This could mean that the trading of instruments
in those markets that are more highly regulated are safer, though possibly less attractive, than in other
markets. Imposition of new conditions could have implications for commitments under the
Understanding, which require that there be a standstill on obligations, and further that established
entities be allowed to offer any new financial service.
11.
One might argue that there is a prudential carve-out. However, the GATS Annex on
Financial Services require that measures imposed must not be used as a means of "avoiding the
Member's commitment or obligations under the agreement." However, an obligation not to restrict
financial services in a situation where a Member wishes to do so, could be interpreted as having the
intention of avoiding that obligation. It would seem that the wording of paragraph 2 of the GATS
Annex on Financial Services may need to be amended.
12.
The question of who has responsibility for subsidiaries of banks in other jurisdictions has
been a matter of great debate during the crisis and of great concern in jurisdictions where some of
these foreign entities failed. Should the government in whose country the institutions are located take
responsibility for their actions and, if so, would this apply to foreign-owned branches and subsidiaries
or to subsidiaries only? These developments have highlighted the need to frame guidelines for
subsidiary and branch operations with respect to bailouts and liquidity support. Positions need to be
developed which require head offices to meet liquidity and other shortages and provide support during
periods of financial difficulties of branches and subsidiaries. There is a greater likelihood of reaching
agreement in the case of branches. However, the legal form should not override the real substance,
and subsidiary operations should also be eligible for support. Already some developing countries are
specifying that foreign operations must be set up in their jurisdictions by way of subsidiaries and not
branches – and with specified capital levels. However, under GATS Market Access rules there should
be no requirement on the specific type of legal entity for those countries which have given such
commitments.5
13.
There are a few associated questions. Should there be an expectation that resources from one
country be transferred to another country to cover shortfalls in an associated subsidiary bank where
the transferring bank is not the head office of the subsidiary? Should one pierce the corporate veil to
determine the flow of funds in order to make such a determination or should it rest on the legal form
of the organization? There is the view in some quarters that the substance is more important than the
legal form. For example, if a branch is operating like other entities in the jurisdiction, which are not
branches, then it should be subject to the requirements which have to be met by other entities,
particularly where such branches are larger than duly incorporated entities in the jurisdiction.
5
Article XVI of the GATS (Market Access) states that there should be no restriction on the particular
type of legal entity.
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14.
The notion of "too big to fail" has been a concern even prior to the crisis, but the financial
crisis realized banking regulators’ worst fears. The concern is that big banks might opt to exercise a
lower level of care because they consider that they were too big to be allowed to fail. The new
financial regulations put in place in at least one jurisdiction in 2010 include a decision to establish an
entity with responsibility to check that companies are not becoming too big as to threaten financial
stability and to devise means of reducing their size. The question now arises as to whether the rules
applicable to large mega banks should be the same as those applicable to smaller banks. Should the
rules vary according to the size and level of sophistication of the entity? Many small entities were
allowed to fail even though, in some cases, their offences were less severe than those of large entities
which were saved. Those who committed to the Understanding may find restrictions on size are
contrary to the commitments given to limit adverse affects on financial service suppliers.
15.
Other proposals for enhanced regulation include the suggestion for a mega-regulator which
would oversee the individual regulators at the national level. The powers of enforcement of such a
mega regulator and the power to impose sanctions would need to be carefully considered, so as not to
endow an institution with excessive power. According to GATS Article XVI, governments cannot
prohibit or limit the size or the total number of financial service suppliers in covered sectors.
However, under a Financial Reform Bill 2010, an oversight entity is to be set up to do exactly that in
one jurisdiction, that is, to make sure that the size of banks is reduced if they appear to be becoming
too large.6
Section 2
16.
In this section we examine some weaknesses in the regulatory system which were highlighted
by the financial crisis.
17.
The crisis also highlighted how important it is that regulators share responsibility for crossborder supervision of financial entities. When bailout funds come from the national treasury of
particular countries, providers of such funds have responsibilities to provide such support to overseas
branches from which their surpluses may well have arisen. These and other questions were high on
the agenda of regulators in developing countries during the financial crisis and seemed to have been
answered differently by various jurisdictions. For the most part, the crisis emphasized the point that
even when problems are international, bailouts tend to be national. There is a need therefore to
develop clearer approaches to determining the relative responsibility of host-and-home country
supervisors and in extreme cases, home-and-host country rescue initiatives. The Understanding
presently places an obligation on the Member to provide access to official funding and refinancing in
the normal course of business. It is up to interpretation as to how adverse the circumstances must be
before they cease to be "in the normal course of business" and when a Member can withhold support
from foreign entities in its jurisdiction.
18.
Understandings forged on relative responsibilities can have implications for how individual
countries write their legislation. Consideration may have to be given to writing legislation to limit the
countries exposure to possible collapses by foreign investors in financial entities, both in the host
jurisdictions and in other overseas operations to which the host entity and hence domestic depositors
are exposed.
19.
There seems to be a need also for international protocols to be developed so that countries are
less likely to opt out of responsibility for bailouts of subsidiaries outside of their borders. An example
from the Caribbean is a case which forms a useful study of the relative rights and responsibility of the
6
assets.
Article XV1 of the GATS (Market Access) states that there should be no limitation on total value of
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parties where there are multiple cross-border financial operations.7 For Members that have not given
commitments under the Understanding, there seems to be even less clarity as to their obligations with
respect to financial support.
20.
Indeed, there are other fundamental assumptions which have been brought into question by
the crisis. While it can be posited that the situation of balance of payments crisis provides an escape
for Member both under IMF articles and under the WTO, permitting Members to take corrective
action, there are two observations which are pertinent. Firstly, Members must be permitted to take
preventative measures, not merely corrective measures. Secondly, the crisis was not a balance of
payments crisis, either for those countries where it originated or for most developing countries. It
would seem therefore that these clauses, based on balance of payments problems, need to be revisited
to include exit clauses which relate not only to balance of payments crises, but which include causes
such as collapse of the financial system and recessionary conditions and excessive fiscal and debt
burdens.
21.
There is an interesting issue concerning whether globalised mega corporations are a weak link
and whether the same issue that arose in global banks could arise in global corporations in the real
sector. This leads to the question of cross-border flows and the question of relating access to credit by
geographic area to the generation of liabilities from dispersed geographic areas. Is there an obligation
for head offices to return liquidity to the geographic area which generated it ? Or should they be able
to siphon funds toward rescue packages for the benefit of the home country, away from foreign
generators of such needed surpluses? So far there has not been much discussion about cross-border
equity in the financing of bailouts.
22.
The examples of the last few years have demonstrated that it was the most systemically
important countries which created the problem for the rest of the world. Developing countries
therefore deserve a bigger voice in setting supervisory standards, particularly with respect to their
offshore impact and foreign subsidiary/branch implications, because when systems fail, developing
countries are seriously affected even though they have had little or no input in the construction of the
rules or the operational guidelines of the institutions. Indeed, while there has been the acceptance of
peer reviews in the world of regulation, there may well be a flaw in such systems since there may well
exist a code of mutual tolerance of shared weaknesses (which may help explain why the whistle was
not blown prior to the crisis), a situation which would have been less likely to occur had the reviews
included non-peers among the reviewers.
23.
It has been suggested that the prudential carve-out in the GATS permits Members to take
action on the grounds that such action is prudentially required. However, there are some aspects to
this which bear further examination. Firstly, when there is an increasing number of exceptions being
introduced on prudential grounds, then this may be a sign that the basic rules need to be addressed.
Secondly, while the prudential carve-out may permit countries to breach their commitments; the fact
is that they have breached their commitments, - albeit with permission. It may be possible to argue
that they are not in contravention of GATS, but they have reneged on the commitments given. In the
case of the Understanding, it is a little more difficult for Members, since there is a proviso that their
actions must not be used as a means of avoiding commitments on obligations. This may well be
exactly what they wish to do in light of recent painful experiences caused by certain types of
activities.
Summary
24.
This paper analyzed the unintended consequences of some of the remedial measures taken to
correct the global financial crisis and some needed changes in our non-operational oversight systems
which the crisis highlighted as in need of modification. The perspective was principally the
international financial governance of the system, the way in which it was affected by the crisis, the
weaknesses revealed, and the long term consequences of some of the remedial measures applied.
7
Par C.1 (National Treatment) of the Understanding on Commitments in Financial Services obliges
members to grant access to official funding and refinancing facilities in the ordinary course of business.
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25.
The paper does not suggest that the remedial measures taken by various governments and
regulators should not have been taken. Indeed, for the most part, they have been most effective. Now
however, given the greater perspective resulting from a longer period of time over which to examine
the issues and their impact, the opportunity offers itself to review some of these measures in the
interest of building a more resilient system for the long term and a more balanced approach to
regulation, which takes into account both the differing impact of both the crisis and the remedial
measures on developed and developing countries.
26.
While it had been probably in order for the WTO to wait until the markets settled and the
regulators had made the appropriate modifications to their regulatory systems before reviewing their
financial services guidelines, perhaps sufficient time has now passed, and it would be possible to
revisit those rules and principles in the light of the lessons of the financial crisis.
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ANNEX
Possible Amendments for Consideration
1.
The following are possible amendments to the GATS, the Annex on Financial Services and
the Understanding, which might be considered for amendment in light of the outcome of the remedial
measures used during the crisis, and with a view to ensuring WTO compliance.
(a)
Section A of the Understanding (Standstill) might usefully be amended to state that
any limitations and qualifications to the commitments noted shall be limited to non
conforming measures as determined at any time by the Member as compared with the
current reading which limits it to limitations and qualifications on existing nonconforming measures. Any alternative wording which achieves this would be
acceptable.
(b)
Paragraph B.10 (d) of the Understanding (Non-discriminatory measures) commits the
Member to remove or to limit any significant adverse effects on financial service
suppliers of measures which "affect adversely the ability of financial service suppliers
of any other Member to operate, compete or enter the Member’s market". Given the
proposed higher capitalization for large entities, this may require amendment. Large
banks are already arguing that the higher capitalization being proposed by the
Financial Stability Board will adversely affect their ability to compete.
(c)
Paragraph B.7 Understanding (New financial services) states that a Member shall
permit financial service suppliers of any other Member established in its territory to
offer in its territory any new financial service. This might need to be amended to give
the authorities some scope to determine which services they wish to discourage, given
the concern about high risk instruments such as hedge funds, short-selling activities,
etc.
(d)
Article XI:2 (Payments and Transfers) and XII (Restrictions to Safeguard the Balance
of Payments) of the GATS may need to be amended. They permit capital controls as
balance of payments safeguards or at the request of the IMF. Those conditions are
related to balance of payments difficulties. Following the crisis of the past three
years, balance of payments crises were rarely the cause of difficulties of capital flight.
There may be a need to cite different exceptions other than balance of payment
difficulties. Other possibilities could include high indebtedness, severe fiscal
imbalances, financial sector instability, etc.
(e)
GATS Article XII:5 requires that the Member consult with the Committee on
Balance of Payments Restrictions. Since there already exist regulatory oversight
bodies governing the financial sector, it might be more appropriate to require that the
WTO be notified and have the BIS, or preferably the IMF, confirm that the
circumstances that led to the withdrawal of commitments fall within permissible
circumstances, and relate to countries’ genuine economic, financial or stability
concerns, thus reducing the resort to possible arbitration. Where challenges occur,
Members are unlikely to be able to await a decision before taking action.
(f)
Article XVI of the GATS (Market Access) prevents limitations on the number of
service suppliers or the total value of service transactions or assets. This may need to
be amended, given the "too big to fail concerns" and the establishment already of an
oversight body in one jurisdiction which can force financial institutions to downsize
or hive off some of its activities should they become too large.
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(g)
Paragraph C.1 of the Understanding (National Treatment) does not require the
Member to supply lender of last resort facilities to foreign service suppliers. Greater
clarity might be needed concerning whether these obligations differ according to the
legal form of the entity.
(h)
Article XVI of the GATS (Market Access) prevents restrictions on the type of legal
entity chosen to be established in the Member’s jurisdiction. This may need to be
amended given that in the post-crisis situation regulators found that they were in a
position to require greater capitalization of subsidiaries, but could do little about
branches. Also, the head office of the financial institution was less influenced by the
local regulator in respect of branches and more so in the case of subsidiaries, leading
to an increasing preference to have financial entities set up by way of subsidiaries
whose soundness could be enhanced by greater capitalization.
(i)
Under Article X:2 of the GATS ("Emergency Safeguard Measures"), Members may
withdraw a commitment only after one year of its implementation, if it is shown that
the withdrawal cannot await the regular three years foreseen for such an action.
However, as per Article X:3 of the GATS, those provisions in Article X:2 ceased to
apply three years after the entry into force of the WTO Agreement. If this is the
correct interpretation, then this section might need to be amended to give authorities
more flexibility.
(j)
Article XXI:2 (a), relating to compensation following a withdrawal of commitments,
could usefully be revisited to include conditions under which this is permitted, as it
could make the cost of protection and the securing of financial stability very costly.
(k)
It is not clear whether the undertaking given in Paragraph 11 of the Understanding
(Non-discriminatory measures) not to restrict "benefits already enjoyed by financial
service suppliers of all other Members" includes remuneration and bonuses. If this
could so be interpreted, this section may need to be revisited as well, given the stated
intention of some countries to place caps on bank executive bonuses.
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