20.12.2009
Financial Architecture: Urgent Repair
№4 2009 October/December
Leonid Grigoriev

Leonid Grigoriev is chief advisor to the head of the Analysis Center under the Government of the Russian Federation, Head of the World Economy Chair of the World Economy and International Affairs Department of the National Research University–Higher School of Economics.

The world began to talk about the necessity to overhaul the global financial architecture long ago: debates have been running for a decade, and hundreds of books have been written, including in Russia. In the late 1990s, the international community intensively discussed the causes of the crisis in developing markets and the role of the International Monetary Fund. The Meltzer Report, drawn by the U.S. Congress, went as far as to offer to reduce the IMF’s role to extending short-term loans to countries with stable finance.

In the autumn of 1999, U.S. Finance Secretary Lawrence Summers (who currently chairs the National Economic Council in President Barack Obama’s administration) summed up the results of the Asian crisis in the following way: countries should determine their fate themselves; there is no alternative to a strong national economic policy; fixed currency rates without a tight fiscal policy is a direct way to complications; “informal” relations between governments increase the risk of crises in the globalizing world; and the coordination of the private sector may play a crucial role in restoring confidence.

This guideline for the reform of the world economy implied its liberalization, together with the establishment of order in developing markets with the view of cutting the Western business’s losses from frequent financial crises. Today, the world speaks about “soft nationalization” as a cure for the financial sector’s groundwork and the state’s “salvation” role in financial crises in the heart of the world liberal economy – the United States.

Earlier, disputes mostly focused on the role of the IMF and other Bretton Woods institutions in developing markets. At present, analysts, governments and central banks have become aware that these problems are essential, and – most importantly – that they actually involve developed countries and their markets. Whereas previously the analysts considered a safer liberalization outside of the core of the world’s private financial system, today the world economy is facing the challenge of saving the very core from “awkward liberalization.” In the past years, nothing drastic was happening in this sphere, because the status quo suited the G7, by and large. The tremendous financial crisis in the U.S. and the global recession in 2008-2009 broke the impasse for this issue.

The world financial system is inherently liberal and will seek – as it pulls out of the crisis – to expand the opportunities for a free movement of capital. But the process of shaping its new architecture is extremely complicated and contradictory because of the conflicts of interests that tend to break out between all the participants. The G20 mainly discusses projects in terms of the global assessment of risks and the monitoring of financial institutions, but it has postponed the revision of approaches to IMF countries’ quotas until 2011. The current recession has been facing resistance from national regulators and some direct coordination by governments. The latter includes a higher level of the protection of deposits, soft nationalization in the banking sector and prevention of protectionist wars. In finance, we see non-confrontational, but independent lines of reform in the United States and the European Union, as well as some original moves made by the BRIC states (Brazil, Russia, India and China).

 The G20’s intention to implement international cooperation remains rather general and vague. For example, no practical accords were reached during the Washington summit (November 2008), which took place at the height of the financial crisis. At the London summit (April 2009), the parties agreed to boost IMF resources, but failed to find accord on principles to modernize the global financial system. The summit in Pittsburgh (September 2009) and the meeting of the finance ministers and governors of central banks in St. Andrews (November 2009) yielded certain tactical accords, such as the commitments to toughen the capital requirements for banks, restrictions on trade of OTC derivatives, etc. But the fundamental issues related to the persistent global imbalances were not fully addressed, and their solution is yet to be found.

Table 1. Objectives and results of the London summit (April 2009)

In many issues, the participant countries hold opposite views (see Table 1), so the new architecture will emerge as a result of long competition between various options. The proposals that are being voiced today provide for a compromise and take into account, to a certain extent, the demands of Germany, France and large developing nations. Anglo-Saxons found themselves at an advantage during the acute phase of the recession: they avoided the necessity to take serious obligations, and no supranational control threatens them. Renaming the Financial Stability Forum as the Financial Stability Board (even with granting membership to Russia and other countries in it) has not changed the practice of international financial organizations or national regulators. The role of financial institutions will inevitably grow in each country, risky foundations will be kept in check with accountability requirements, and the number of offshore companies will decrease. After the crisis, the world will resemble its pre-crisis version, although many objective processes have been unfolding regardless of the success or failure of G20 consultations.

KEY PROBLEMS OF THE GLOBAL FINANCIAL SYSTEM

The excessive leverage (ratio of loan capital to funds at one’s disposal – Ed.) of the financial system in general and of developed states in particular shows the basic imbalance between the capital of financial institutions and the size of assets they are managing. In the first place, it concerns the high risk components, such as complex derivative financial instruments. The writing-off of huge volumes of “bad” assets in 2008-2009 was a still larger drain on the financial system.

The U.S. government measures have not been very effective so far: during the “credit crunch” the disorientation of banks and investors is an obstacle to a smooth start of the traditional mechanisms that provide for liquidity and availability of loans. Further financial upheavals after the beginning of the industrial depression are a normal thing; it was the financial shock prior to the industrial recession that was unique. In the course of the crisis, loans are shrinking gradually as the cumulative volume of credits also suffers complications: the overall (nominal) volume of bank loans tends to stagnate (except in China), but banks are forced to extend loan terms. They would be happy to have their money back, but they have to extend the repayment periods to avoid the risks of default or losing their clients in the future (see Graph 1)

As the U.S. economy draws out of the crisis, it is likely to keep relatively low growth rates. An increase in the U.S. population’s savings (to 5 percent of the available income, as in the 1990s) will provide additional resources to the national financial system – provided the increase is steady. President Barack Obama’s fiscal stimulus may prove to be very expensive and create a record high budget deficit in the next few years. But in a longer term there is a chance that the U.S. economy will not require that much external funding. The net decrease in the obligations of households may become the fundamental factor in deleveraging the entire economy, i.e. the population’s savings can secure a relative decrease of the future demand for capital inflow.

Graph 1. Cumulative volume of bank loans in the U.S., Eurozone, Russia and China (2006-2009, 2008 average = 100)

Source: Bank of Russia, U.S. Federal Reserve System, Institute for Energy and Finance

In a bid to countervail the outgoing offer of commercial loans, the state has sharply expanded its obligations. A decrease in the government’s obligations and its withdrawal from the funding of the economy will be a drawn-out and hard process. The crisis has proved that the presence of a limited number of huge financial institutions is an inherent system risk.

The increased level of financial globalization in the past two decades has not been counterbalanced by a relevant increase in the level of control and regulation. Despite the seeming abundance of information, the financial players have been displaying an extremely low level of information transparency. The crisis has revealed a dangerous tendency: hedge funds, private equity funds and investment companies give grudgingly information which could be helpful in evaluating risks. The risks in the system began to accrue faster and on a greater scale than ever, and became increasingly difficult to identify. This resulted in painful consequences, unexpected for regulators (especially in small countries with large banks), which have not yet found ways to rectify the situation. There was no sufficiently authoritative body to assess system risks outside of the network of the established institutions. A change of the model and format of the banking system (more complicated operations, investment banking and securitization) will require entirely new regulating capacities.

The failure of national regulators and international financial organizations at the early stage of the crisis in the summer and autumn of 2008 was one of the reasons behind general mistrust on the markets. The immediate result was the investors’ loss of confidence in financial authorities, institutions and a majority of instruments except for state securities of the U.S. and some other countries. The problem aggravated on negative news about the global industrial recession. Among other things, the current crisis is marked by a global scope and a lack of a “safe haven” for investors.

The financial globalization and gradual removal of regulatory requirements facilitated the concentration of the financial sector on a global scale. The number of financial institutions, regarded as too large to go bankrupt, became too big even for such major economies as the United States. In some small states (Ireland, Iceland, etc.), the financial institutions that were relatively small by world standards appeared to be disproportionately large compared with the sizes of their national economies. The advantages from the enlargement of such loan institutions have proven to be quite illusory, because running such large bodies and full-fledge risk management become more complicated. Also, large financial institutions have a considerable political influence and can change the rules of the game in their favor – something they practiced not only in developing markets, but also in the markets of developed economies.

The market of credit derivatives, above all credit default swaps (CDS), became one of the main factors which destabilized the world financial markets. The positions on these instruments resulted in the bankruptcy of Lehman Brothers and the de-facto nationalization of AIG. The high concentration of contracting parties and the asymmetric information, stemming from complex patterns of inter-relations and cross-hedging between the actors is the main problem of the market of credit derivatives. Although the key function of credit derivatives is to lower risks, the overall level of system risk has increased. Furthermore, the speculative change of the CDS value, which occurred due to the market’s specifics, may be regarded as a worsening of credit worthiness, and become a separate cause of financial panic.

The markets of derivatives have come under particularly harsh criticism, and therefore their de-regulation has become a thing of the past. Now we can expect a decrease in the volume of derivative financial instruments and more transparency of the related financial obligations – certain moves have been made or are currently under consideration. Additional collateral requirements and centralized trade make these instruments less attractive for investors, which may result in the shrinking of these markets.

In general, derivatives increase the effectiveness of the financial system, but they should be subject to separate regulation and control. This measure helps to lower risks and meets the interests of the world financial system as a whole. The practice of the so-called ‘securitization’ and creation of ‘structured’ financial products in general made a negative contribution to the current crisis. ‘Securitization’ was viewed as a universal pattern for eliminating risks, speeding up the financial turnover and deriving quick profits. The rapid expansion of securitization decreased the incentives for monitoring the initial credit risks and the actual quality of high-rating securities.

It is necessary to change the criteria for regulating banking, because the Basel Standards no longer reflect the changes in the activity of the major banks. Globalization has erased the boundaries between various types of banking operations. In addition to the traditional functions of financial mediators, banks act increasingly often as operators on the stock and currency markets both in their own interests and at their clients’ instructions. The Basel Standards are obviously pro-cyclic: during an economic boom, the fixed norm for capital sufficiency contributes to the buildup of both capital and assets. During an economic recession, it aggravates the crisis because it is necessary to cut assets in order to comply with the regulators’ requirements.

The decreased dependence of financial markets on ratings and assessments by international rating agencies has become the topic of the year. The experience of the recent years has shown that in awarding their ratings, the agencies do not take into account the increased scope of the use and diversification of financial instruments. Since investors and regulators in the whole world rely on ratings by international agencies, their quality must be dramatically improved.

The establishment of an international regulator is hot on the agenda, but the proposal is unlikely to materialize for political reasons. The U.S. program (June 2009) envisions “coordination,” but the United States does not intend to let a supranational body to supervise its financial markets and institutions. In practice, the functioning of financial institutions involves higher risks, because the terms of assets and liabilities in a financial institution always differ. The operation of national central banks aims to lower the degree of risk due to the central bank’s position of a “creditor of last resort,” with the right to turn on/off the money press. Since no such creditor is available at the supranational level, it is one of the factors behind the increasing system risk. Financial markets are playing an increasingly larger role and can become a source of panic, which can be prevented by a supranational creditor only.

As yet, there is no system of international regulation of the financial sector harmonized between the key players, in the least. In various financial sectors, there is a set of standards and codes that are developed by international organizations and supported by the IMF and the World Bank. They are the reference points for national regulators and three international rating agencies. But the established system does not ensure a real regulation of the financial market and institutions at the global level, or a rapid response to crises. The activities of such organizations as the Basel Committee on Banking Supervision, the International Organization of Securities Commissions, the International Association of Insurance Supervisors, the Committee on Payment and Settlement Systems, the Financial Accounting Standards Board are still disjoined.

There is a need for a body with supranational functions, which would work out uniform approaches to the regulation of various segments of the global financial market. There has been much talk about it recently, and the G20 noted it among their objectives. By a twist of fate, the U.S., whose financial system came under the bulk of criticism, has become the leader of new trends. At the same time, it is already obvious that the leading countries are not ready to give away part of the regulatory, supervisory and controlling functions and powers to a supranational body.

In our opinion, the decrease in the U.S. role as a financial center will be the inevitable consequence of the crisis of the international financial system. The crisis shows that the excessive concentration of finance – when one country consumes the greater part of free global savings – is unstable by definition.

We are far from agreeing with those who say that the prognoses about the quick end of the dollar era and of the U.S. as a financial center are beginning to come true. The role of the U.S. dollar in the world is foremost based on the huge supply of reliable dollar assets to private and state investors. As a reserve currency, the dollar has traversed the boundaries of its country, providing for not just securities for private investors, or cash for settlements by countries with unstable currencies, but also huge volumes of official reserves. Even the decrease of the dollar-denominated reserves at central banks to 40 percent from the record-high 56 percent in the early 2000s, leaves the holders with a growing mass of over $2.5 trillion of dollar assets (see Graph 2).

Graph 2. Official reserves of countries, U.S. dollars, and share of dollar assets in reserves, % (1995-2008)

Source: COFER

The U.S. financial system did a “great Swiss service” to the rest of the world, giving it the opportunity to keep savings in reliable assets. Thereby, the country attracted rather cheap resources for its development under quite sensible principles of reliability. This had a positive influence on the stability of the global system, as it ensured the transfer of risks in time and space. The inflow of foreign capital to the U.S. played a major role in the economic development of the country in the distant and recent past. Those who wish to see the “funeral” of the dollar might count on a lesser role of the U.S. currency in international settlements and central banks’ reserves in the medium-term perspective. But it is difficult to conceive a scenario where the dollar would lose its key role at least in the next decade. A flight from the dollar might become a drawn-out trend, remaining extremely susceptible to the situation on currency markets, especially as the common interests of the holders of dollar assets prevent the “catastrophes” that the mass media predicts so willingly.

Is the G20 capable of functioning effectively? Such a format was designed a decade ago to discuss the reform of the financial architecture. The legitimacy of this group is insufficient, because world problems should be either resolved at the UN or on the basis of a set of measures approved by national parliaments (or, rather, both ways).

We are actually witnessing informal coordination of political vectors and their subsequent implementation by individual countries or groups of countries such as BRIC or the Franco-German coalition. The level of the current recession lets us say that the leaders have coped with the famous maxim of physicians “First, do no harm!” Even if the positive dynamics of the stock markets after the summits is the result of different, much deeper economic trends (which is probable), nothing prevents us from believing that the summits have a therapeutic effect. The very discussion about the reform of the international financial architecture acts as a stabilizing factor. After all, the G20 summits send the correct message about the importance of international coordination and prevention of protectionism.

Following the crisis, there have appeared two plans to overhaul the world financial architecture instead of one: American and European. The U.S. plan, presented in the Department of the Treasury’s report, Financial Regulatory Reform – A New Foundation: Rebuilding Financial Supervision and Regulation, aims to resolve five key problems.

First, traditional regulation is targeted at the activity of certain institutions, not the system as a whole. Regulators did not pay enough attention to the system risk. Solution: higher requirements across the board and extra requirements for large players, as they create the system risk. Also, it is proposed to boost the responsibility of the Federal Reserve for exposing system risks. Our opinion: the main problem which led to the crisis was not the banks’ not meeting the norms but the fact that compliance with these norms did not necessarily show the capability of the financial institution to resist the crisis.

Second, securitization and distortion of incentives amidst greater securitization of bank loans. Solution: demand to disclose information, increase the level of inquiries to keep part of loans on the balance of the issuer, and transfer the greater part of derivative financial instruments to exchange floors to study the related risks. Our opinion: many banks kept the larger part of assets in “toxic” securities as it is, and it is difficult to give a quality assessment of disclosed information.

Third, a low level of the protection of investors’ and consumers’ rights. Solution: setting up an agency to protect consumers’ rights, to regulate the financial sector at the retail level. Our opinion: politically, it is the most understandable and attractive part of the plan, which should be implemented accurately.

Fourth, the regulators have no necessary instruments for taking actions in critical situations. Solution: authorize the FRS to provide support to any financial company (not just to loan institutions) if its collapse can jeopardize the stability of the financial system with risks. Our opinion: this will merely give legal backing to the solutions that were realized through administrative procedures.

Fifth, the availability of international regulatory arbitration allows financial companies to operate in the most convenient jurisdictions, which lowers the effectiveness of any measures at the national level. Solution: coordination of actions at the international level. Our opinion: in practice it means an increased U.S. pressure on offshores and jurisdictions with low taxes and regulation. There has been no coordination of a more substantive level thus far.

The purpose of the plan is to make regulation more sophisticated and precise, that is, to complicate it. In our view, it is necessary to give more authority to the regulators (they have all the required instruments, but they do not use them) and streamline regulation. The more complex the regulating system is, the more ways there are to circumvent it.

The initiatives of the European Union have been indeterminate so far, they are behindhand the American proposal and are eclectic due to the tremendous – and currently insurmountable – contradictions within the European Union. There is a visible bid to limit the freedom of action and tax havens in offshores. The key issues for the EU, related to the regulation of banks operating in several countries, have not been resolved either.

The progress in pan-European regulation has been insignificant so far. For example, there are plans to form a new European Council for system risks, but its decisions will be recommendatory. The plans actually concern the structure of the European Central Bank, that is, they will practically change nothing.  It is planned to set up a European System of Financial Supervisors to regulate the institutions operating in several countries, but in essence it is a pool of national regulators trying to regulate large institutions along uniform, but not yet formulated principles. The main problem of the financial sector of the European Union is that the institutions are regulated at the national level, while the greater part of operations is done on the pan-European market. Some small states (Belgium, Ireland and even Switzerland) do not have enough financial resources to bail out their large banks.

The recession has hit hard all the 12 East European EU members, so any system measures on a pan-European scale would immediately require a considerable overflow of resources from the “old” Europe-15 to the “new” Europe-12. But the European solidarity in the conditions of recession does not stretch that far, especially amidst the suspicions regarding the economic policy pursued in Central and East European states.

WHO WILL PAY FOR DEVELOPMENT?

One may discern another discussion unfolding behind the disputes over the future financial architecture – that of the sources of funds and forms of global development after the crisis is over. In general, the shaping of common strategies of developing nations remains the monopoly of international financial institutions. The instruments of influence are the measures to support fiscal budgets and current accounts, as well as assistance to large projects, including the development of power generation, infrastructure, and the financial sector. The developed states can use the International Monetary Fund and a system of development banks to influence the policy of many countries (including countries of Eastern Europe and Asia), and this influence is disproportionate to their expenditures.

Graph 3 shows the dramatic decrease in the overflow of financial resources from the Western private financial system to developing countries during the acute phase of the crisis. In the first half of 2008, overall funding exceeded 250-260 billion dollars, whereas during the same period of 2009, it hardly exceeded 100 billion dollars. The financial system was at a standstill for several months in late 2008 (it seems that part of the money flows went to/from offshores). In such a situation, the developing countries find themselves almost in complete dependence on international financial institutions. A certain increase in overflows in the autumn of 2009 reflects a number of sovereign borrowings and a certain revival after oil prices increased to 75 to 80 dollars per barrel. This phase of the crisis is marked by the issuance of equities, as borrowing appears difficult. The growth of equity capital flows occurs amidst the depressed state of the world banking system, which has not yet recovered from the 2008 shock.

It is necessary to seek possible answers to both threats: on the one hand, the loss of funding for long-term projects in Asia, Europe and Latin America, and, on the other, the recurrence of dependence on international financial institutions controlled by the G7. Further development will be influenced by the countries and forces which will be able to offer clear strategies, effective projects and long-term low-interest funding of such projects.

The global financial system does not correspond to the new structure of the world economy, in which the role of the largest developing countries (BRIC plus hydrocarbon exporters) has increased both in terms of the size of their economies and their accumulated gold and forex reserves. As a result, reinvestment of national savings by many countries, including Russia, turned out to be mediated by external financial centers, which has proven to be a serious threat to development in the conditions of instability.

Graph 3.  Gross capital flows to emerging markets, 2008-2009, bln USD

Source: World Bank

Curiously, BRIC states have shown greal interaction and certain practical moves in the reform of the financial architecture. A revision of the quotas and voting rights at the IMF and the International Bank for Reconstruction and Development has been postponed until 2011. But it turned out that amidst the liquidity crisis and a huge shortage of funds the BRIC states received the status of major “creditors,” not “shareholders” at the IMF. China has contributed 50 billion dollars to the IMF; Russia and Brazil, 10 billion dollars each, as a two-year loan in the form of bonded debt. Therefore, fresh liquidity for the solution of urgent problems (including the Ukrainian crisis) came from BRIC. Accordingly, the decisions to use it have one important feature: they should be harmonized with the approaches of these “new creditors” to solving world problems, otherwise it will be difficult to refund the above 70 billion dollars in two years (the IMF might fail to have free funds in 2011). So the world architecture has actually begun to change for yet another reason – under the influence of recession and in favor of large developing countries with a positive balance of payments.

We can state that the American and European ways of revamping the system are complemented by a not very large, but extremely important component in the IMF. In the long term, there will remain the question of how (and at whose expense) global problems will be addressed. These problems include climate change, reaching the millennium goals, the struggle against poverty, and sustainable development of many countries. We are yet to see if new (regional) currencies and financial development centers will appear, how independent they will be, and if they will be able to take responsibility for ensuring world economic growth and stability. Yet these are objective trends, which they will gradually gain momentum as international life goes on.

During the crisis, the world financial system served as the strongest destabilizing factor of internal development of developing countries. The deepening recession, the restructuring of the U.S. and EU financial systems, the steps by Russia and other BRIC states to realize their own interests will shape a new financial architecture more actively than theoretical debates or agreements.

Russia’s role in the world financial architecture is unlikely to be as significant as many would wish it to be, but given sensible alliances and compromises, it may become quite sufficient for protecting its national interests. The current situation should be used to modernize Russia’s own financial system, increase its resistance to external shocks, and, most importantly, its ability to convert internal savings into domestic investments in development, without the risky dependence on external financial markets and institutions.