What is the future
of
international finance?
John Eatwell
Centre 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 System
1944-1971
• 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 nontradable 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 macroeconomy 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 microrisks, 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 “piggybacking” 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
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