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The past year witnessed three of the most dramatic financial collapses since the Third World debt crisis of 1982. The meltdown of the Mexican peso in December 1994, the failure of the 233-year-old Barings Bank last February, and Daiwa Bank's $1 billion loss in November--apparently at the hands of a single trader--would all seem to point to a financial system that has spun out of control.
In June 1974, when the small German Bankhaus Herstatt floundered, the contagious effect was immediate: interest rates rose, the Euromarkets (the London-based markets for dollars and other hard currencies) shriveled, and the integrity of the American payments system was threatened. The 1982 debt crisis led to even greater anxiety about a possible catastrophe, and the payments system was kept in motion only by the injection of huge amounts of cash by the industrial countries and the International Monetary Fund (IMF).
But last year the markets responded to these financial crises with little more than a "ho hum." In fact, the U.S. stock market boomed, and interest rates around the world declined. The Bank of England allowed Barings to fold, and nothing happened. American regulators closed Daiwa Bank's New York office, and the markets did not squeal. Both inside and outside the U.S. government and international organizations, analysts continue to debate whether the Mexican bailout was really necessary.
What explains this sea change in the reaction of international markets to financial shocks? Over the past 20 years the leading economic powers have created a regulatory structure that has permitted the financial markets to continue toward globalization without the threat of systemic collapse. The elimination of financial contagion has required painstaking efforts by dedicated public servants who have had to navigate between domestic political pressures and concerns about the well-being of the international system.
One school of thought, represented by the consultant Keniche Ohmae and the economist Richard O'Brien, views the international economy as supranational, the nation-state as increasingly irrelevant to its healthy operation. But rather than demonstrate how the expansion of markets is a product of eroding state power, the historical record shows that concerted state action has made possible the sustained growth of international finance. The "formula" that central bankers adopted for the regulation of global markets places the responsibility for their supervision clearly on the state. The regulatory model was international cooperation based on home country control, meaning that no bank would be allowed to operate unless a single national regulator had supervisory responsibility for all its operations, both foreign and domestic.
Central bankers live under the shadow of the Great Depression. During the 1930s, the global financial system collapsed: more than one-fifth of all American banks ceased operations, and major banks failed throughout Europe, particularly in Germany and Austria. By some accounts, the prolonged economic crisis contributed directly to the rise of Hitler and the outbreak of World War II. Public officials watched these events from the sidelines, and international efforts to shore up the banking system were notable for their failure.
The lessons of this traumatic period resonate in the contemporary discourse on financial markets. Bankers and officials often express fear that a crisis in one country could spread like wildfire around the world. As Federal Reserve Board Chairman Alan Greenspan told a Japanese audience in 1992, "A failure by one of these [financial] institutions . . . could result in serious systemic problems." Greenspan was pessimistic, as is his charge. But he might have noted the progress of financial regulators in containing crises and the role that international cooperation has played in this endeavor.
International collaboration among financial regulators has its origins in the wake of two banking failures of 1974, those of the Bankhaus Herstatt and the New York-based Franklin National Bank. In response to the international crisis that ensued, the central bankers of the Group of Ten (g-10) industrial countries voted to create the Standing Committee on Banking Regulations and Supervisory Practices, now commonly known as the Basle Committee. These policymakers faced a problem that was straightforward yet complex: while money and banks might cross borders, they could not. To compound their task, the members of the g-10 had very different financial rules and systems. In Germany, for example, "universal" banks handled nearly all commercial and investment banking functions and dominated the financial markets; in others, with the United States representing the extreme case, the system was highly fractured, with thousands of financial institutions and a confusing web of regulations and regulators.
Faced with this situation, the central bankers' objectives, articulated in the 1975 Basle Concordat, were appropriately modest. They aimed to share information about banks and regulatory systems and to identify which national regulator had primary responsibility for overseeing the activities of the increasingly international financial institutions. The Basle Concordat laid down the general principle that no international bank would be permitted to escape supervision. It further stated that "parent" or "home" country authorities would be responsible for the oversight of bank solvency. Finally, it urged home and host countries to share information about the activities of multinational banks.
The Basle Concordat, however, remained murky on several important is-sues. First, the Germans had indicated they would not bail out any banks that had failed due to fraud, yet fraud was one of the major causes of bank failure. Second, the accord did not define who would bear responsibility for the supervision of subsidiaries abroad. Third, even if parent and host authorities shared information, regulators might still be unable to construct a complete picture of a multinational bank. This could be achieved only with a consolidated set of books and a single regulator assigned overall responsibility, which the Basle Committee later recommended.
These gaps became apparent during the troubled summer of 1982, beginning with the collapse of Italy's Banco Ambrosiano and ending with Mexico's announcement that it had suspended its debt payments. Taken together, these events pointed to a fragile international payments system that still lacked effective supervision. The Ambrosiano failure was a classic case of the problem of regulatory responsibility. Although it was an Italian bank, Ambrosiano's troubles originated in its Luxembourg subsidiary. The Bank of Italy claimed that it was not responsible for overseeing that operation. Luxembourg's authorities said much the same thing. While the regulators argued, the Euromarkets stopped lending to small and less-known banks, which were perceived as relatively unstable.
As the Ambrosiano drama played itself out, an event occurred that would claim the world's attention for a decade. The Third World debt crisis officially began when Mexico announced on August 12, 1982, that it lacked the hard currency to meet its obligations to foreign banks. The debt crisis raised the specter of another Great Depression, with the world's most prominent banks tumbling as Third World countries defaulted on their loans. As Benjamin Cohen wrote, "Should the Mexican storm spread to other major Latin borrowers . . . there was no telling what might happen to the structure of international finance--or to the whole world economy for that matter."
During the summer and autumn of 1982, Federal Reserve Board Chairman Paul Volcker and Treasury Secretary Donald Regan fashioned a two-pronged strategy for dealing with the debt problem. Their objective was nothing less than maintaining the integrity of the international financial system. One prong entailed injecting enough liquidity into the system, through bilateral and multilateral grants and loans to debtors, to prevent its break-down. The longer-term plan was to strengthen the international banks that were now on the brink of collapse by requiring them to increase their equity. Beyond that, Volcker and Regan sought to use the crisis to force developing countries to adopt significant changes in economic policy.
A major actor in implementing this strategy would be, of course, the IMF. But to play this heightened role, the IMF would need a larger budget, and its member countries, the most important of which was the United States, would have to approve these funds. In the summer of 1982, however, Congress had little enthusiasm for the IMF, the debtors, or the banks, particularly after the grueling recession of 1980-81. One U.S. Treasury official present at the annual meeting of the IMF and the World Bank in September of that year wrote that the atmosphere was "almost universally morose. Fear was widespread that the world's banking system would collapse, bringing an implosion of credit, then trade, and ultimately an inevitable worldwide depression."
In early 1983 the Reagan administration requested an $8.4 billion increase in the U.S. IMF contribution. The response was predictable: in the words of Senator Jake Garn, chairman of the Senate Banking Committee, "There will be legislation . . . so we can go home and say we didn't bail out the big banks." Congress told the administration that it would have to propose a package of new and more stringent banking regulations before the IMF request would be considered. The most important aspect of the administration's plan concerned capital adequacy, the ratio of capital to assets. The American authorities stated that henceforth they would "analyze a bank's capital adequacy in relation to the level of diversification of the bank's international portfolio. Those institutions with relatively large concentrations will be expected to maintain generally higher overall capital ratios."
In subsequent hearings, however, American bankers vigorously opposed this call for higher levels of capital. They argued that unilaterally imposed regulations would place them at a competitive disadvantage at a time when they were already losing market share to European and Japanese banks. Since new regulations translated into higher banking costs, institutions with relatively low regulatory burdens could charge less for their services, winning new customers. To level the playing field, they demanded, if the United States insisted on any new regulations, Europe and Japan should also have to adopt them.
The senators felt strongly that the banks had to boost their ratios of capital to assets. If each bank went out and raised more capital, it would help restore confidence in the financial system as a whole. Moreover, greater capital would mean that shareholders--and not just taxpayers--would cover some of the costs associated with debt-crisis relief. But they were also sensitive to the bankers' pleas regarding competition. The obvious solution was to promote international convergence in banking regulations, starting with capital adequacy. As part of the approved IMF increase, Congress called upon "governments, central banks, and regulatory authorities of other major banking countries to work toward . . . strengthening the capital bases of banking institutions involved in international lending."
For the next three years, the Basle Committee debated the issue of setting a single international capital adequacy standard. Originally viewed by most of the member countries as an absurd idea, owing to the sharp differences between their banking systems, America's vigorous insistence ultimately led to a g-10 agreement in December 1987. Along with the Basle Concordat, the Basle Accord represents the cornerstone of international financial regulation.
The Basle Accord sets minimum standards for capital adequacy for all international banks, and it ties capital levels directly to portfolio risk. If banks don't meet this minimum level, they must either shed assets or raise more capital; if they exceed it, they may be rewarded by better credit ratings, higher stock valuations, and entry into new markets. Alongside the Basle Committee, other international bodies, such as the International Organization of Securities Commissions, have adopted similar capital adequacy and market risk regulations for investment banks, and such basic standards now apply to all banking institutions in the European Union. These gauges provide consumers, credit agencies, and securities analysts with signals for judging the true strength of financial institutions. Today, many banks report their capital adequacy measures in their promotional materials.
The fruits of these regulatory efforts have been significant portfolio diversification and an important increase in the capitalization of international banking. These changes mean that the system is less exposed to danger by a single irresponsible actor--be it a Bank of Credit and Commerce International or a Barings.
The financial difficulties of 1995 point to the strength, rather than the weakness, of the international regulatory structures. In each case--Mexico, Barings, and Daiwa--the worst effects have been contained. As a result, international markets have continued to function normally.
To be sure, in the case of Mexico extraordinary action was deemed appropriate, although many observers both within and outside of Congress continue to doubt the urgency of President Clinton's request for emergency aid. International markets moved little in the wake of the peso's fall, and Martin Wolf of the Financial Times expressed the skeptic's view of the crisis when he wrote that the U.S. intervention to help Mexico "can be justified, therefore, by the desire to help the U.S.'s neighbor . . . but this has little to do with the global financial system."
Similar quietude followed the collapse of Barings Bank in late February 1995 at the criminal hand of a young derivatives dealer, Nicholas Leeson. Many chicken littles had predicted during the late 1980s and early 1990s that trading in derivatives--futures, swaps, and options--would trigger the next global financial crisis. But they overlooked the important role that derivatives have played in moderating systemic risk, providing banks with increased opportunities to diversify their portfolios and protect themselves from sudden market shifts. The Basle Committee has amended its accord to account for derivatives trading. Significantly, the Bank of England did little to reassure markets during the Barings collapse.
Reckless speculation in securities markets was also behind Daiwa's $1 billion loss, leading to the closure of its New York office in November by American authorities and the subsequent forced restructuring of the bank by Japanese officials. Not only did this loss fail to generate shock waves, but the bank itself was large enough to contain the damage.
What is significant about these three contemporary cases is that in each the effects did not spread to international markets, although some South American markets did feel aftershocks from Mexico. Many innocent Mexicans and Japanese will be hurt by the financial collapses and losses in their countries, and that is tragic. But the rest of the world has been largely sheltered, and in a world of global finance, that is no small achievement.
The international financial markets have not suffered from contagion because the roots of the disease have largely been eradicated. Thanks to international cooperation, at the core of the new regulatory structure lie better supervision, common banking standards, and higher, risk-based capital levels. Market actors have responded by organizing bigger and better-capitalized banks. Because of these reforms, Russian banks, although allegedly flush with cash, are having a hard time obtaining licenses to operate overseas. Both the lax Russian regulatory regime and most (if not all) of the country's banks fail to meet international criteria.
One could argue that this increase in financial security has come at a cost. Around the globe, large institutions are coming to dominate the markets, squeezing out the smaller banks that have played a significant role in venture capital, real estate development, and community-based lending. Although these small banks have been prone to failure in the past, due to poor management and lack of diversification, they have also provided important services and an entrepreneurial flair which large banks, based in the world's financial centers, may not possess. In the absence of these players, small and medium-sized enterprises could find it more difficult to obtain the financing they need; this problem has already come to the fore in Germany, where some fear that the country is losing its economic vibrancy owing to the lack of venture capital and associated entrepreneurial activity.
The trend toward international regulation, be it at the global level in Basle or at the European level in Brussels, also has important political consequences. Traditionally, financial regulations were, for better or worse, embedded within domestic politics, meaning that a variety of special interest groups lobbied for preferences and protection. As regulatory structures are increasingly removed from their domestic political setting, it is becoming harder, if not impossible, for local financiers to influence policy choices. Only the largest banks will be able to lobby Basle and Brussels.
The international economy may pay a price for its greater financial security. We have found a way to contain crises, but "creative destruction," to borrow Joseph Schumpeter's phrase, could be the victim. The next challenge for banking regulators is to maintain a watchful eye on the marketplace without choking the very dynamism they seek to encourage.