Washington’s Dangerous New Consensus on China
Don’t Start Another Cold War
It is time to take stock of the G-20. Just over five years ago, during the free fall of the global financial crisis, representatives from 20 of the world’s leading economies agreed to gather twice a year in order to develop a more sustainable regulatory framework for financial institutions.
There have been many signs of promise. The group has agreed on a new framework for regulatory standards for each country’s most important financial institutions and tasked a Financial Stability Board (FSB) with monitoring adherence to them. But the G-20 has also fallen short of some expectations. Although there have been improvements in global financial regulation over the past five years, serious flaws remain.
The G-20 has already addressed the main pillars of financial regulatory reform. The most important decision concerned international bank capital regulations. Prior to the G-20, there were serious problems. The Basel II agreement, initially published in June 2004, gave banks enormous discretion in determining whether they met minimum capital standards. That agreement was also undermined by the fact that the United States decided not to live up to it.
The Basel III regulations, which were agreed upon in 2011, were a great improvement. The first important step was that all the G-20 countries agreed to recognize the regulations and task a new body, called the Regulatory Consistency Assessment Programme (RCAP), with monitoring, assessing, and evaluating the implementation of new, more stringent capital standards. The RCAP audits the regulatory frameworks of participating countries and issues formal publications evaluating their progress. It has the authority to request improvements as necessary, and has done so. In each of the four countries it has reviewed, it has requested improvements -- 90 of them, in the case of China. In a preliminary assessment, the European Union was declared materially noncompliant on two items, and the United States was declared materially noncompliant on one item.
Another achievement of the G-20 was the creation of a regulatory framework for over-the-counter-derivatives, risky financial instruments that were at the center of the last financial crisis. Before the crisis, there were essentially no regulations on the riskiest derivatives trading and there was no transparency in the derivatives marketplace. Now the majority of these transactions are bound to multilateral standards of transparency and regulation. Although these ideas were discussed by the G-20, ultimately the United States and Europe -- where 85 to 90 percent of derivatives trading is conducted -- are primarily responsible for implementing them. Although most countries have passed laws implementing these regulations, it is too early to tell whether they are working.
A third accomplishment of the G-20 was its reforms to international regulations on rating agencies. Before the crisis, ratings agencies, which are responsible for assessing the ability of debtors to pay back what they borrow, were unregulated in most G-20 countries. After the crisis, it was clear that this was a grave mistake. The industry was highly concentrated, with two U.S. firms controlling more than 80 percent of the market. But the ratings issued by these agencies were often sloppily fabricated.
The assumption behind the new regulations was that greater transparency and scrutiny of ratings agencies would encourage competition and improve overall performance. Preliminary data suggest that the plan has worked. In the United States and the EU, new entrants have joined the market and a greater number of firms are now rating financial institutions and asset-backed securities.
The G-20 has also succeeded at regulating hedge funds. Before the crisis, hedge funds were dealt with in different ways in different countries. (Even the EU lacked a single regulatory framework.) All G-20 economies, with the exception of Brazil, have now passed hedge fund regulations as part of broader efforts to regulate and supervise the shadow banking sector, which involves entities and activities (including hedge funds) that exist fully or partially outside the regular banking system.
Finally, the G-20 has made major progress on standards for winding down troubled banks. During the crisis, the lack of such standards proved to be a major problem, as the lack of a common playbook worsened market jitters. The need for a clear resolution scheme is especially relevant for large cross-border banks, which are especially difficult to unravel and are concentrated in the United States and the EU.
Resolution regimes require a clear operational authority to stabilize the bank, as well as a clear legislative framework that allows authorities to force creditors to take losses. It is already evident that such a system is easier to build in the United States than the EU. The United States already has a clear authority, the FDIC, which is responsible for taking control of the parent company of the distressed financial group. It has always been capable of keeping distressed operations open by injecting extra liquidity. The FDIC can also access an Orderly Liquidation Fund (OLF), administered by the U.S. Treasury, to finance a “bridge” bank, which is authorized to hold the assets and liabilities of an insolvent bank. A bridge bank is charged with continuing the operations of the insolvent bank until the bank becomes solvent through acquisition by another entity or through liquidation.
The EU is only halfway there. Although Europe has agreed on the procedure to resolve a bank, the proposed common fund for that kind of activity is, at 55 billion euro, still too small given the size of the EU banking market, and will only come in place too late. In practice, national governments will still likely be responsible for providing most of the money to assist their ailing banks, which would only worsen the distortions in European financial markets.
LONG ROAD AHEAD
The G-20 still has plenty of work in coming years. New financial regulatory items have emerged on the agenda, including regulation of the non-bank financial sector. International standards for the non-bank financial sector are far less developed than those for banking. In July 2013, the FSB published a list of nine insurance companies (five are European, three are American, and one is Chinese) that it deemed systemically important. It will soon publish a similar list for other finance and asset management companies. Although the size of total assets of insurers and asset management companies is far below that of the banking sector, and systemic risks are much lower, their business models and risk diversification still require proper supervision.
The G-20 regulations have also not yet solved the problem posed by central counterparties (CCPs), the entities that increasingly serve as an exchange for derivatives transactions. They play a critical role, but are still under-regulated: at periods of financial stress, they may not be able to meet the liquidity needs of their members. If inadequately managed, CCPs could become the Fukushimas of global finance. CCP board members need to take a much more hands-on approach to insulating risks coming from CCPs.
The G-20 also needs to place greater emphasis on macroeconomics, especially when it comes to coordinating exit policies from the unconventional monetary policy that developed countries have pursued since the start of the crisis. The prospect of the end of such policies -- namely, the U.S. Federal Reserve’s decision to draw down its bond-buying program -- has already led capital to flee emerging markets. Similar policies are sure to follow in the other developed countries. Whether central banks will take the global dimension into account remains an open question.
Overall, the G-20 has taken a big step toward instituting better global governance and a more consistent regulatory framework for financial markets. Five years on, the G-20 countries -- and especially the United States and Europe, where the seeds of the last financial crisis were sown -- have largely delivered on their commitments. Better rules are in place on bank capital, derivatives, ratings agents, hedge funds, and bank liquidation. How these rules are enforced will matter, of course, but at least the rules exist. Initial reports on the implementation of the new Basel III rules, which are key to the entire framework, are already promising.
That raises the question of how the G-20 has managed to enforce its agenda without possessing coercive authority. One important factor has been the quality and dedication of its leadership. The past and current chairs of the FSB, Mario Draghi and Mark Carney, were instrumental in driving the process forward. But another factor has been the subtle effectiveness of peer pressure. Although the G-20 cannot force any single country to pass regulations, each country is very aware of being observed by the others. No member of the group has wanted to be accused of shirking its responsibilities. For now, that should be enough for the G-20 to move forward on its remaining agenda.