The G-20’s “Summit on Financial Markets and the World Economy,” held in Washington on November 15, gave world powers a chance to coordinate their responses to the burgeoning international financial crisis and accompanying ills in real economies around the globe but produced a long, vague, and telling declaration, devoid of meaningful commitments to change business as usual.
The Group of 20 includes large developing countries like China, India, Indonesia, Mexico, Brazil, Argentina, and South Africa, so the meeting did at least expand participation beyond the limited scope of typical G-8 meetings, which include only the world’s richest countries plus Russia. At the same time, most countries of the world (including all of Africa, except South Africa), were excluded. Civil society groups criticized it for bypassing the more inclusive United Nations.
The declaration, released after the summit, got short shrift in a busy news cycle that’s lurching from one massive bailout maneuver to the next. But it’s a significant — and contradictory — document. On the one hand, it identifies regulatory and financial institution failures, and calls for new regulatory measures. On the other hand, it includes various odes to the free market, and urges forward some of the institutions and processes that helped create the financial and economic crisis. Unfortunately, while the declaration identifies important regulatory failures, almost all its action items are at a level of generality that make them impossible to measure and potentially of little or no consequence.
Absent altogether from the declaration are big ideas and proposals for structural shifts. Also notably absent is a commitment to shrink the financial sector, so that it serves rather than engrosses the real economy. Here’s a detailed analysis of many of its key passages.
Common Principles for Reform of Financial Markets
Regulators must ensure that their actions support market discipline, avoid potentially adverse impacts on other countries, including regulatory arbitrage, and support competition, dynamism and innovation in the marketplace.
The first half of the sentence is a welcome, if somewhat innocuous, characterization of financial regulators’ job: They should help financial markets check risky behavior by making sure risks are fully disclosed, and they should avoid a race to the bottom in regulatory standards (“regulatory arbitrage”), in which big financial institutions drive down standards in one country by complaining that they are too tough as compared to another country.
But the second half of the sentence commits financial regulators to perpetuating existing problems. In general, innovation is crucial to economic development, but not “innovation” in the financial markets. The current financial crisis stems in part from too much innovation — too many complicated and exotic financial instruments growing too fast, with too little supervision, too little understanding by market participants of what they are doing, and too little comprehension by anyone of the systemic threats posed by new instruments. In general, we need less dynamism and innovation in financial markets. The evidence of the last decade strongly suggests the need to prohibit certain financial instruments altogether, and to require that new financial instruments pass regulatory review before being permitted to be introduced on the market.
We will exercise strong oversight over credit rating agencies, consistent with the agreed and strengthened international code of conduct.
Credit ratings agencies — the leading agencies are Moody’s, Standard & Poor’s, and Fitch — played a central role in the financial crisis. As banks and investment banks packaged home mortgages and other loans, investors looked to ratings agencies to assess the level of risk in these combination investments. The ratings agencies gave the highest rating, AAA, to debt obligations that quickly proved to be of low quality. Credit ratings agencies have additional power because regulatory rules say that banks investing with borrowed money need to set aside less collateral to buy higher-rated instruments.
Internal documents from ratings agencies show what a shoddy job they did. The U.S. House of Representatives Committee on Oversight and Government Reform procured a 2007 document in which the head of Moody’s stated, “analysts and MDs [managing directors] are continually ‘pitched’ by bankers, issuers, [and] investors” and sometimes “we ‘drink the Kool-Aid.'” An S&P employee wrote, “It could be structured by cows and we would rate it.” Another S&P employee stated: “Rating agencies continue to create [an] even bigger monster — the CDO market. Let’s hope we are all wealthy and retired by the time this house of cards falters.”
The ratings agency failure wasn’t a matter of incompetence. Ratings agencies are paid by the entities floating a bond. They have an incentive to please the entity, to make sure they get repeat business.
Stronger regulation can help reduce this problem. In the United States, amazingly, the Securities and Exchange Commission must give passing grades to credit rating agencies that apply their principles correctly, even if the underlying rating principles are flawed. But even stronger regulation cannot overcome the structural bias by credit ratings. The problem could be solved by making credit rating a public function, with government or nonprofit entities assigned to do particular ratings jobs, without the ability of a bond issuer to choose who will rate its bond.
In consultation with other economies and existing bodies, drawing upon the recommendations of such eminent independent experts as they may appoint, we request our Finance Ministers to formulate additional recommendations, including…reviewing compensation practices as they relate to incentives for risk taking and innovation
Compensation practices in the financial sector are a key problem. Excessive pay has helped drive a culture of inequality, encouraging other CEOs and executives to demand lavish salaries. It’s outrageous for public bailout monies to be spent on massive compensation packages; on principle, the leaders of failed institutions should be penalized, especially if their vast pay packages are theoretically tied to performance and shareholder value during boom times.
More important, however, is the issue the declaration does directly raise: financial sector compensation systems reward risky, short-term behavior and even provide incentives for management recklessness.
Wall Street bonuses are paid on a yearly basis. If your firm does well, and you did well for the firm, you get an extravagant bonus. This is not a few thousand dollars to buy fancy Christmas gifts. Wall Street bonuses can be 10 or 20 times base salary, and commonly total as much as four-fifths of employees’ pay. In this context, it makes sense to take huge risks, whatever the risk of failure — and especially if the failure is likely to occur sometime in the future (meaning any time after this year). The payoffs from benefiting from a bubble are dramatic, and there’s no reward for staying out.
However, to do something about excessive compensation, you have to be serious about it. The $700 billion U.S. bank bailout required measures to deal with excessive compensation. The Treasury Department’s executive compensation guidelines for banks participating in the bailout are laughable. The most important rule prohibits incentive compensation arrangements that “encourage unnecessary and excessive risks that threaten the value of the financial institution.” Do banks need to be bribed with hundreds of billions of dollars to persuade executives not to adopt incentive schemes that threaten their own institutions with unnecessary and excessive risk?
A meaningful standard must be much tougher. One desirable approach would not only cap top pay levels, but insist that large bonuses must be tied to company performance over a long period (say, seven years).
We recognize that these reforms will only be successful if grounded in a commitment to free market principles, including the rule of law, respect for private property, open trade and investment, competitive markets, and efficient, effectively regulated financial systems. These principles are essential to economic growth and prosperity and have lifted millions out of poverty, and have significantly raised the global standard of living. Recognizing the necessity to improve financial sector regulation, we must avoid over-regulation that would hamper economic growth and exacerbate the contraction of capital flows, including to developing countries.
Perhaps the Bush administration required this invocation of “free market principles” as a condition of signing on to the overall document.
It’s hard to imagine how anyone could avoid breaking out with disbelieving laughter upon reading this. As of late November, Bloomberg calculates, the U.S. government will have committed $7.76 trillion — more than half of GDP — in a bewildering array of bailout monies, swaps, guarantees, discounted loans, insurance programs, share purchases and more. Where, oh where, is the “free market” in this? And doesn’t the public have a right to demand control commensurate with the support the government is offering financial and nonfinancial firms?
We underscore the critical importance of rejecting protectionism and not turning inward in times of financial uncertainty. In this regard, within the next 12 months, we will refrain from raising new barriers to investment or to trade in goods and services, imposing new export restrictions, or implementing World Trade Organization (WTO) inconsistent measures to stimulate exports. Further, we shall strive to reach agreement this year on modalities that leads to a successful conclusion to the WTO’s Doha Development Agenda with an ambitious and balanced outcome. We instruct our Trade Ministers to achieve this objective and stand ready to assist directly, as necessary. We also agree that our countries have the largest stake in the global trading system and therefore each must make the positive contributions necessary to achieve such an outcome.
Existing World Trade Organization rules (in the General Agreement on Trade in Services, or GATS) already impede countries’ ability to maintain appropriate financial sector regulations, and new GATS proposals would further restrict countries’ ability to maintain or adopt sound financial regulations.
As a “development” matter, the WTO’s Doha Round of trade talks promises developing countries benefits in the form of improved market access to rich countries, including the United States. But the inherent shortcomings of this model are now apparent, as the poor countries that depend on the revenue they get from exporting to rich countries are experiencing deep trouble due to their integration with shrinking economies. Even worse, in the last quarter century, the export-oriented development model has really been based on sending products to the United States. Even apart from the global recession, the United States will be a shrinking market, because the country’s trade and current account deficits are not sustainable. Thus the development potential of an export-oriented economic model is poor.
Millennium Development Goals
We are mindful of the impact of the current crisis on developing countries, particularly the most vulnerable. We reaffirm the importance of the Millennium Development Goals, the development assistance commitments we have made, and urge both developed and emerging economies to undertake commitments consistent with their capacities and roles in the global economy. In this regard, we reaffirm the development principles agreed at the 2002 United Nations Conference on Financing for Development in Monterrey, Mexico, which emphasized country ownership and mobilizing all sources of financing for development.
The Financing for Development (FfD) initiative has evolved into something more than call for money for development aid. At the end of November, country representatives will gather in Doha, Qatar to review a proposed document, following up on the original Monterrey FfD meeting, calling for a review of the “international financial and monetary architecture, and global governance structures.” In the eyes of many critics, the G-20 process aims to head off developing countries’ demands for a more fundamental review and reform of global financial structures, as well as to preempt a more genuinely multilateral approach. The fact that the heads of the International Monetary Fund and World Bank declined to attend the Doha conference may undercut it as well.
The Climate and Other Challenges
We remain committed to addressing other critical challenges such as energy security and climate change, food security, the rule of law, and the fight against terrorism, poverty and disease.
The G-20 may be committed to these other challenges, but they aren’t putting commensurate money on the table. Using a very conservative assessment of U.S. government outlays on the financial crisis, a recent study from the Institute of Policy Studies (IPS) finds that rich countries are spending 40 times more on the financial crisis than on development aid and climate change finance combined. The actual ratio is arguably much greater — IPS fixes U.S. expenditures on the financial crisis at $1.4 trillion, far below the $7.76 trillion figure from Bloomberg. (Bloomberg includes financial supports not included in the IPS calculation.)
Accounting standard setters should significantly advance their work to address weaknesses in accounting and disclosure standards for off-balance sheet vehicles.
Holding assets off the balance sheet generally allows companies to exclude “toxic” or money-losing assets, including debt, from financial disclosures to investors in order to make the company appear more valuable than it is. This was central to the Enron scandal. Since 2003, however, the Financial Accounting Standards Board (FASB) requires companies to disclose special purpose entity (SPE), or special purpose vehicle (SPV) financial data on balance sheets. In addition, Section 401(a) of the Sarbanes-Oxley Act requires public disclosure of all material off-balance sheet transactions, arrangements, and obligations. Disclosure systems mechanisms remain problematic, however, and even now no one is sure of banks’ ongoing and overall liabilities, in part because they are parked in off-balance sheet entities. To that extent, enhanced disclosure would be an improvement.
But the bigger question is why off-balance sheet operations should be permitted at all. The whole idea of balance sheets is to honestly report assets and liabilities. Use of off-balance sheet vehicles has directly and significantly worsened the current economic crisis. Banks used off-balance sheet operations — SPEs and SPVs — to hold securitized mortgages. Although derivative instruments related to these mortgages were sold off to other entities, the SPVs themselves often maintained the actual mortgage liability. And thus the ultimate liability remained with the banks. Because the securitized mortgages were held by an off-balance sheet entity, however, the banks did not have to hold capital reserves as against the risk of default — thus leaving them vulnerable and undercapitalized.
Supervisors and regulators, building on the imminent launch of central counterparty services for credit default swaps (CDS) in some countries, should: speed efforts to reduce the systemic risks of CDS and over-the-counter (OTC) derivatives transactions; insist that market participants support exchange traded or electronic trading platforms for CDS contracts; expand OTC derivatives market transparency; and ensure that the infrastructure for OTC derivatives can support growing volumes.
Credit default swaps are effectively a kind of insurance policy — or, less generously, a bet — on debt securities. An investor or company contracts with another party (the “counterparty”) to provide insurance on any of a wide range of debt instruments, and if the bond doesn’t pay, the counterparty must make up the loss.
There were about $62 trillion in outstanding credit default swaps as of October 2008. There is a theoretical benefit to credit default swaps — to the extent they provide insurance, they help parties cushion potential losses, just like home insurance would. But any insurance system runs the risk of enabling excessively risky behavior — and in the case of the current financial crisis, it is clear that credit default swaps did exactly this.
The G-20 proposes to standardize credit default swaps, so they are tradeable, more transparent, and easier to value. These steps would all be improvements over the current situation. But doesn’t a financial meltdown that is, by consensus, the worst since the Great Depression signal the need to think differently? The hypothetical benefits of credit default swaps can’t begin to offset the damage they have created. The G-20 would have performed a much greater service if it signaled an intention to consider phasing out credit default swaps altogether or at least prohibiting parties with no stake in the underlying transaction from taking them out.
Managing Risk and the IMF
Firms should reassess their risk management models to guard against stress and report to supervisors on their efforts.
The declaration is peppered throughout with this kind of meaningless and empty hortatory language. The financial crisis has demonstrated beyond doubt that financial firms’ internal risk control measures are inherently flawed. Even diligent firms — apparently in very short supply — seem unable to incorporate the risk of systemic problems, where individual problems compound each other rather than being isolated.
In that context, systemic risk management is vital. But the G-20 show little readiness to adopt sufficiently robust measures to address the problem. One measure of their failure is the reliance on the International Monetary Fund to sound early alarms about systemic risks.
The IMF, with its focus on surveillance, and the expanded FSF [Financial Stability Forum], with its focus on standard setting, should strengthen their collaboration, enhancing efforts to better integrate regulatory and supervisory responses into the macro-prudential policy framework and conduct early warning exercises.
There’s a lot of talk about the IMF getting an enhanced “surveillance” role, meaning a greater responsibility for identifying problems before they emerge. But this is already an IMF responsibility, one at which the Fund has failed miserably.
In the IMF’s April 2007 Global Financial Stability Report, issued just before the financial crisis first spun out of control, Fund economists reported that:
- Risk of serious problems from subprime loans was minimal: “Major dislocation [related to subprime loans] still appears to be a low-probability event,” (p. 10).
- Banks had risk under control: “Most observers agree that risk management practices have improved at regulated banks and brokers” (p. 60).
- Hedge funds needed some greater oversight, but steps as small as greater reporting requirements would risk undermining “innovation”: “Industry observers and participants generally agree that any new initiatives related to hedge fund oversight should seek to preserve hedge funds’ contribution to financial stability against the new or emerging risks their activities pre-sent. Costs associated with new requirements (e.g., reporting systems, legal infrastructures, etc.) may drive some funds from the market and deter new funds from entering the market at the possible costs of reduced competition, innovation, market liquidity, and risk dispersion” (p. 61).
Not exactly the kind of predictive record that offers hope for the future.
The IMF, given its universal membership and core macro-financial expertise, should, in close coordination with the FSF and others, take a leading role in drawing lessons from the current crisis, consistent with its mandate.
One among many lessons the IMF should draw from this crisis — as it should have drawn from earlier crises — is that countries must be free to impose strong restraints on the financial sector and financial flows.
More important, perhaps, is the ability to impose capital controls limiting the ability of funds to flow into and out of the country. Capital controls limit the vulnerability of national currency to speculative attack. They can also give developing countries policy space to undertake expansionary economic policies (more spending and lower interest rates), as their local currency becomes somewhat decoupled from developments in international financial markets.
IMF studies have shown that capital controls were helpful for countries employing them during the late 1990s Asian financial crisis, but the IMF generally remains hostile to such measures.
Adapting the IFIs
We should review the adequacy of the resources of the IMF, the World Bank Group and other multilateral development banks and stand ready to increase them where necessary. (International financial institutions) should also continue to review and adapt their lending instruments to adequately meet their members’ needs and revise their lending role in the light of the ongoing financial crisis.
The IMF has made some tentative steps in recent months that suggest it’ll issue some loans without the harmful conditions it traditionally attaches. But no-condition loans — if there are any — appear to be available only to favored countries. Poorer countries, most in need of expansionary policies, continue to be instructed to pursue contradictory policies as a condition of loans. Even Iceland was forced to raise its interest rates to an extraordinary 18%.
If the IMF is to receive additional resources to make emergency loans, then these new resources should come as part of a package that focuses IMF operations and moves it away from harmful past practices. A network of civil society organizations has urged that these include:
- An end to the IMF’s involvement in development aid, including a closing of two IMF facilities, the Poverty Reduction and Growth Facility and the Policy Support Instrument.
- A guarantee that loan conditions not intrude on matters — such as privatization, trade liberalization, and labor market rules — not related directly to balance-of-payments problems.
- Assurances that borrowing countries will maintain policy space to support expansionary economic policies, including especially the right to spend more money on healthcare and education.
- Debt cancellation for poor countries.