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Three years have passed since the sub-prime problems that eventually led to the devastating global financial crisis first surfaced. Though we now have a fair grasp of the causes of the crisis, remarkably little has been done to address the weaknesses in domestic and international financial regulation. The few reforms that have been pursued have serious drawbacks. With global financial vulnerabilities on the rise again, decisive action, led by the G20, is needed.

The Need for Financial Stability Regulation

The overleveraged financial system and inadequate capital and liquidity buffers that led to the crisis arose from a “perfect storm” of factors: regulatory shortcomings, macroeconomic imbalances, and financial firms riddled with poor risk-management systems, flawed securitization processes, and compensation structures that encouraged a focus on the short term. Supervision of the financial system had fallen prey to the “fallacy of composition”: with each individual institution deemed sound, the entire system was assumed to be healthy. In reality, however, system-wide risks were building.

Now there is widespread agreement that the avoidance of large macroeconomic imbalances and financial bubbles is essential for reducing the risk of future crises. As stated by the International Monetary Fund (IMF), Bank for International Settlements (BIS), and Financial Stability Board (FSB) in a report to the G20, macro-prudential regulation—that is, a set of rules and institutions that aims to mitigate macroeconomic and financial imbalances—is an essential tool for achieving such financial stability.

Criteria for Effective Regulation

Any serious proposal to establish a regulatory framework for financial stability not only has to include clear objectives and well-defined accountabilities, but must also ensure that regulators have adequate resources and an effective approach to implementation. In addition, regulation has to conform with a number of criteria:

• Inclusion of Stakeholders: Because numerous risks lie outside the oversight of banking supervisors and central banks, their views must be complemented by those of securities and insurance regulators, finance ministries, and debt managers. Within each country, a multidisciplinary, multi-agency regulator is essential.


• Scope: Both central banks and fiscal authorities need to be involved in three key areas of financial stability: liquidity provision, prescriptions and proscriptions for the behavior of financial actors, and solvency support.


• Independence: The regulator must be independent of political considerations and separate from the micro-supervision of individual banks. Also, it must be independent of the political system and the interests of other institutions.


• Accountability: Clear objectives, a clear mandate, and clear processes for preventing, managing, and resolving crises are needed to make accountability possible. Sanctions or other forms of punishment should be imposed on the regulator if it performs inadequately.


• Authority: The regulator should not be conceived of as a simply “reputational” body comprised of high-level members who influence by moral authority alone. The regulator needs binding powers and the ability to impose measures on other regulatory bodies and financial institutions.

Furthermore, regulation has to be coordinated at the international level in order to minimize regulatory arbitrage and protect countries against external shocks. Here, legitimacy is key.

• Legitimacy: The institution charged with coordination of international regulation must be established by international agreement and be responsible to its member governments. It must be representative and should have voice, independence, and no conflicts of interest. The institution must also have clearly delegated authority and responsibility.

Evaluation of Reforms

How do the regulatory reforms undertaken in the main financial centers and at the international level after the crisis stack up against these criteria? Not well, unfortunately.

EU

In September 2009, the Commission of the European Communities proposed the creation of several EU-level agencies to supervise systemically important cross-border banks and other financial institutions, markets, and instruments. These include the European Systemic Risk Board (ESRB), a steering committee, and a technical advisory committee.

The approach has glaring limitations. It fails on inclusion: it does not take a multidisciplinary, multi-agency approach to systemic risk. With more than 61 members, the process is unwieldy and central banks remain heavily over-represented. There is no clear distinction between the European Central Bank (ECB) and the ESRB; the ECB dominates the process with analytical support and voting rights. Furthermore, the proposed structure lacks accountability, clear objectives and processes, and a strong mandate. In particular, the ESRB is a “reputational” body. Its recommendations are not legally binding, although the recipients of recommendations must respond once a risk has been identified. Finally, the cross-border framework for managing and resolving crises is weak. The conflicting proceedings and competencies impede information-sharing and collaboration.

United States

The bill currently under debate in the United States would create a Financial Services Oversight Council, chaired by the Treasury Secretary and including the chairman of the Federal Reserve and the heads of six regulatory agencies. The council is remarkably similar to the President’s Working Group on Financial Markets.

The proposed approach fails to streamline the U.S. financial regulation system. In particular, it lacks independence, as the chair (the Treasury Secretary) is obviously not immune to political considerations. And, although the council brings all regulators to the table and can develop “heightened prudential standards” for individual institutions, it cannot manage systemic risks, such as consumer debt overhang. Finally, the proposed Council lacks the authority to take binding decisions and fails to outline an explicit process for authorizing the use of fiscal resources, which should be subject to congressional scrutiny.

International Action

There has been a similarly glaring lack of progress on the international level. During the crisis, policy makers rightfully rushed to pull together existing entities, which had been established by historical events (and accidents), to support financial stability.  In April of 2009, the BIS-hosted Financial Stability Forum was re-established as the Financial Stability Board (FSB) with broader representation, including national financial authorities (central banks, regulatory and supervisory authorities, and ministries of finance) from the G20 and other countries, international financial institutions, and standard-setting bodies. The FSB has a sweeping mandate to address vulnerabilities and develop and implement strong regulatory, supervisory, and other policies in the interest of financial stability. However, this arrangement lacks legitimacy, independence, and accountability, and it is not representative.

The G20 needs to unravel the FSB, let go of the anachronistic BIS setting, and establish an independent organization with legitimacy, transparency, and accountability to the world at large.

IMF-sponsored multilateral consultations on global imbalances have also made little progress, as shown by the IMF Executive Board’s recent discussion on strengthening financial sector surveillance. The modus operandi of the IMF and FSB efforts to ensure the stability of the international monetary system still appear to be in their preliminary phases. The only other tangible reforms to date are designed to resurrect Basel II, which focuses on a traditional set of regulatory tools for strengthening the ability of individual institutions to absorb shocks, but does not address systemic transmission of risks.

Looking Ahead

With global financial vulnerabilities rising again, the urgent need for an international regulatory body is increasing. The European Central Bank recently warned that the global distortions that provided the backdrop for the financial crisis threaten to widen again and the Greek crisis reflects the strong headwinds ahead.

With little progress to date on meaningful reforms, leadership in the international financial community is needed. The G20 needs to unravel the unmanageable spaghetti bowl the FSB represents and let go of the anachronistic BIS setting. It must establish an independent organization with legitimacy, transparency, and accountability to the world at large. Such an institution must be independent of the G7 and have its own capable, forthright, independent, and impartial staff. In the absence of decisive G20 action, we can expect only delayed regulatory action in response to formidable lobbying by vested interests.

Michael Pomerleano, on external service from the World Bank, is currently advisor on financial stability to the Bank of Israel.