The start of 2011- let’s call it Year Two A.G. (“After Greece” debt crisis) – has brought both good and bad news on the economic front. The bad news is that 2 A.G. is beginning much like 1 A.G. ended, with headlines about government debt and default, this time focused on Portugal and Spain. The good news is that Europe continues to make steady progress in redesigning the architecture of the financial system that melted down during the economic crisis that began in 2008.
In the latest sign of progress, this month will see the launch of four new supervisory agencies that will police Europe’s financial institutions and protect consumers and taxpayers. The four agencies include the European Banking Authority (EBA), European Insurance Authority (EIOPA), European Securities and Markets Authority (ESMA), and a European Systemic Risk Board (ESRB), chaired by the President of the European Central Bank that will monitor and warn of excessive risk in the financial system and economy.
The new E.U. regulators will have the power to ban trading in certain financial instruments, and to settle disagreements between national financial regulators. They also will be able to give direct instructions to banks and other financial actors in crisis situations and in cases where national regulators are in clear breach of E.U. rules. They will also draw up technical standards to be applied by national regulators. These regulatory bodies are the centrepieces of the European Commission’s efforts to reform the financial industry in the wake of the crisis, and they will oversee the enforcement of other reforms that already have been passed or are in process.
“This is a very important result. We have the foundation of a new European supervision,” said Michel Barnier, the European commissioner for the internal market.“ He described the new structure as “the control tower and the radar screens that the financial sector needs…This is just a first step…we will dispose of a framework in which the Commission will continue, brick by brick, piece by piece, to propose elements.”
Various international bodies, especially the Group of 20, have been important forums for trying to coordinate a global approach to financial reform. The United States, from where the financial cancer initially spread, also has legislated various financial reforms, the primary American vehicle being the “Dodd-Frank Wall Street Reform and Consumer Protection Act.” But generally America’s reforms have not been as comprehensive or as far-reaching as those passed in Europe, resulting in much frustration both internationally and in the U.S. Below is a scorecard of progress in both Europe and America on banking and financial reform.
1. Cash reserves for banks. Europe has led the way, via the Basel III process, in requiring banks to maintain higher levels of cash reserves as a cushion against investments that go bad. Basil III has called for a quadrupling of reserves, though some of the German banks have fought this and managed to delay the implementation date. The U.S. has yet to make firm commitments in this regard, though they are likely to do so by the end of 2013.
2. Skin in the game. To prevent Goldman Sachs and others from creating investment vehicles that they know are designed to fail, Europe will require the packagers/originators of all asset-backed securities to retain at least 5% “skin in the game,” meaning they must retain ownership of 5 percent of those securities they have created. This will provide an incentive to be more careful underwriters of securities since some of their own money will be at risk. The U.S. is requiring something similar, but its rules are much narrower in scope, requiring 5% skin only for the originators of subprime mortgage-backed securities.
3. Bonus crackdown. To address the negative role that remuneration practices played in encouraging risky investment behaviour by executives, the E.U. has issued comprehensive new rules linking bonuses more closely to salaries, issuing bonuses in non-cash instruments such as company shares, and establishing a “claw-back” mechanism whereby bonuses can’t be collected for several years to ensure that current business practices don’t result in a future meltdown. American controls in this regard remain mostly nonexistent, beyond enhancing the role of shareholders to provide some oversight.
4. Hedge fund crackdown. The E.U. has issued comprehensive new rules governing the structure, activities, marketing, capital and liquidity requirements for all hedge funds. U.S. rules are considerably more lax, requiring only that hedge funds register with the Security and Exchange Commission.
5. Derivatives/Volcker Rule. The big debate over the $600 trillion derivatives market – which is ten times larger than the GDP of the entire world – was whether derivatives and other types of speculative investments should be removed from commercial banks (which hold the deposits of thousands of individuals), since the huge amount of speculative investments represent a potential threat not only to individual banks but to the banking system itself. To counter this, the Volcker Rule called for some degree of reinstatement of the Glass-Steagall Act by separating commercial/retail banking from speculative investment banking. That would “make banking boring again,” as some pundits have put it, and taxpayers wouldn’t be on the hook if the speculative investments turned sour since the gambles wouldn’t have been made with government-insured deposits.
Here, many experts believe that Europe continues to play with fire by declining to separate derivatives trading from depositor banking. Instead, European regulators so far have opted only for more transparency by moving derivatives trading out of the shadows to public stock exchanges where they will be traded and processed by clearing houses that have to comply with stricter governance rules. Trade repositories with databases will be set up to collect data on the status of derivatives contracts to give regulators a better insight into potentially risky deals. This is one area in which the U.S. has led Europe, with Dodd-Frank prohibiting any U.S. bank from investing 97% of its core capital in risky investments like hedge funds, as well as requiring more transparency (though see below for a recent E.U. proposal to limit speculative investments by banks deemed “too big to fail”).
6. ‘Too big to fail’. Related to the Volcker Rule, both Europe and the U.S. have been criticized for their reluctance to break up any bank deemed to be so big as to represent a potential threat to the financial system. But European regulators have devised another way to approach this. Recently the European Commission, the executive arm of the E.U., has proposed giving regulators the power to block new products (such as derivatives) and limit trading risks at banks and financial institutions that would need “extraordinary public support” during a crisis because they are so large. The European-led Financial Stability Board, a global group of regulators and finance ministry officials, is in the process of identifying financial institutions “of such size, market importance, and global interconnectedness that their distress or failure would cause significant dislocation in the global financial system.” Such banks would be subject to tougher regulation and oversight.
7. Credit rating agencies. The Big Three rating agencies, Moody’s, Fitch’s and Standard & Poor’s, have engaged in corrupt practices such as selling AAA ratings to companies and to investments they knew had been designed to fail. They continue to add to the sovereign debt crisis in Europe by degrading bond ratings of certain countries based not on economic fundamentals but on speculative hype. So Europe is looking to vigorously change the equation here, moving supervision of rating agencies to one of its new regulatory bodies which will have significant powers of inspection of rating activities. It has levied new rules to require greater disclosure of information provided to the rating agencies by the companies and investments they are rating, not only breaking up a cozy, insider game in which the raters were paid by those they were rating, but also allowing for unsolicited ratings by other, more industry-independent agencies. The United States also has passed some reforms, including providing more oversight from the Securities and Exchange Commission, more transparency of ratings methodologies and new rules to prohibit conflicts of interest and to create liability for any rating agencies’ reckless use of information. But the U.S. approach has been to encourage a reduction in overall reliance on ratings for investment decisions, while the E.U. wants greater competition for the Big Three rating agencies.
8. Overall regulatory supervision. The four newly launched E.U. agencies have been praised by experts because they will result in clear lines of responsibility and have the potential for greater E.U. coordination of supervision. But the U.S. has shifted the primary responsibility for financial regulation and oversight to an already overwhelmed Federal Reserve Board, and to the Office of the Comptroller of the Currency. Experts have stated that the new U.S. system “appears to compound problems created by a patchwork approach to supervision, and additional responsibilities for the Federal Reserve for systemically risky institutions create uncertainty about the location of ultimate responsibility for supervision.”
Other proposed reforms include redesigning the terms of future bailouts so that private creditors, such as banks, hedge funds and bond holders, take the hit for at least part of the losses, instead of only taxpayers. Previous reforms include bestowing more oversight power to Eurostat, the E.U.’s statistics and data collection agency, to audit budgets of member states to provide more transparency and to ensure that no country can submit falsified finance reports (like Greece did with the help of Goldman Sachs). Europe also has launched a trillion dollar rescue package, a kind of European Monetary Fund that can help prevent the default of a member state and generally act as a financial backstop for euro zone countries. For the first time in its history, eurozone members are loaning money to each other, a momentous development for countries that fought bloody wars against each other not that long ago. In return, procedures are being developed that will require member states to adhere to certain agreed limitations regarding fiscal expenditures and low budget deficits, a clear step towards a tighter fiscal union.
So despite the PIIGS crisis, 2010 was an important year of reform. Indeed, one of the silver linings of the crisis has been that it has provided a mighty stick for prodding member states further down the path of reform. This is resulting in nothing less than a redesign of the global financial system. In comparing the E.U. and U.S. scorecards, Paul Horne, former managing director at Smith Barney/Citigroup, has said that “the E.U.’s new architecture must be rated as ‘very significant’,” but that “the Dodd-Frank legislation is more a reshuffling of the regulatory patchwork and may not address the underlying structural problems. Says Horne, “The eurozone, and by extension the whole E.U., has emerged strengthened by the showdown over Greece and other E.U. countries with unsustainable budgetary policies that were being pushed toward default by the bond vigilantes.”
Contrary to what eurosceptics like Paul Krugman, Wolfgang Munchau and others have written, Europe has not dithered or sat back helplessly. Quite the contrary, it has been a busy and productive year, albeit a difficult one. Using its trademark practice of multilateralism and consensus-building, Europe has painstakingly pieced together the direction and details for a new economic order. Sure, often Europe has been in a reactive mode, but that is how reform usually occurs– in reaction to a crisis. And certainly many European banks are still in poor shape, refusing to lend money even as they boost corporate profits to try and balance their overleveraged balance sheets. Europe has been criticized for not doing enough to re-stimulate its economies, but the financial issues confronting both sides of the Atlantic are extremely complex and interlocked. It was wise to wait until a healthier financial architecture is in place, otherwise you would likely replicate the conditions that contributed greatly to the economic meltdown, i.e. launch a new round of bubble-driven, debt-ridden economic growth. Once new policies and procedures are established they will be exceedingly difficult to change, so it makes sense to take time and get it right.
But will all these reforms be enough? Will these efforts establish a healthier global economy ready for the challenges of the 21st century? In truth, nobody knows. Until these new regulatory bodies and laws have had a chance to work it is difficult to predict their effectiveness. And any real assessment must include a re-evaluation of the values and goals of the global banking and financial system. In a newly designed economy, what should be the proper role for banks? What are the desired goals for a financial system? If we frame this in terms of values, we should be asking, “What is the proper social function of a bank?”
The world can’t afford a financial system that has lost sight of the crucial difference between productive investment and gambling, between the banker and the bookie, and between the insurer and the speculator. We must take steps to recreate our financial institutions in response to the real needs of Main Street and not just Wall Street. The youngster euro zone – barely a decade old – has learned some hard lessons about fiscal and monetary unions, and now appears to be inching its way toward a new financial system, and by extension a new economic order. But it’s a work in progress, ongoing in 2 A.G.
Now if only Europe can get its laggard transatlantic cousin to pick up its pace, 2011 could be a banner year not only for economic recovery but for establishing the path for a healthier and more stable global economic order.
Sources for this article include:
“The EU Takes On Banking and Financial-Services Regulation,” EuroWire, Bertelsmann Foundation, October 2010, www.bertelsmann-stiftung.de/cps/rde/xbcr/SID-83ABC83D-68279FF2/bst_engl/xcms_bst_dms_32455_32456_2.pdf.
“Post-Crisis Financial Reform: A Trans-Atlantic Scorecard,” by J. Paul Horne, November 2010,
“Brussels launches clampdown on derivatives,” EurActiv, September 22,2010, www.euractiv.com/en/financial-services/brussels-launches-clampdown-derivatives-news-497783.