Thursday, April 23, 2009

Towards a new system of financial regulation

by Philip Whyte

The financial crisis is often portrayed as the product of weak regulation in the Anglosphere. But it is more accurate to think of it as the result of flawed thinking (and policy) across the global financial system as a whole. One reason is that countries outside the Anglosphere have also experienced unsustainable credit and housing market booms. Another is that differences in regulatory systems are smaller than is often supposed. The lesson of the crisis is not, as Nicolas Sarkozy and Jean-Claude Juncker seem to think, that Anglo-Saxons must move in a European direction. It is that all countries must converge on a new regulatory model.

It is not hard to see why the attention of European politicians should have zeroed in on regulatory flaws in the US – it is, after all, where the financial crisis broke out. There are unquestionably important lessons to be learned from the US experience – particularly in relation to the ‘shadow banking system’ and securitisation (the process of originating loans, then packaging them up as securities and selling them on to the market). But the financial crisis has done more than simply expose flaws in the US’s regulatory model. It has also called into question the very principles on which institutions the world over have been supervised.

The first flaw that the crisis has exposed is the ‘pro-cyclicality’ of financial regulation. Regulation did nothing to mitigate the expansion of leverage, credit and house prices. Capital adequacy rules did not become more constraining during the upswing, while accountancy rules exacerbated the downswing by forcing firms to sell assets at distressed prices. So the regulatory framework did not provide enough of a check on banks at the top of the credit cycle – but compounded their problems when the cycle turned. Lesson: the regulatory framework must be redesigned so that it mitigates, rather than exacerbates, the credit cycle.

A second problem brought to light by the crisis is that regulators were not paying enough attention to liquidity. For the past twenty years or so, international discussions between regulators have concentrated overwhelmingly on solvency – that is, how much capital financial institutions should hold to cushion themselves against losses on their banking and trading books. But many of the institutions that were brought low by the crisis (such as Northern Rock and Lehman Brothers) ran into trouble because their sources of funding dried up. In effect, regulators had spent the past twenty years preparing for a right hook, but ended up being floored by an upper cut. Liquidity will loom larger in regulation than it has done to date.

A final flaw that the crisis exposed is the belief that the stability of a financial system follows inexorably from the soundness of its individual constituents. What this belief ignored was that institutions were more interconnected (and hence vulnerable) than was previously realised; and that actions by individual institutions to maintain their own stability could, when copied by all their peers, push the system itself to collapse. In short, regulatory regimes paid too much attention to the supervision of individual institutions (micro-prudential regulation) and not enough to the system as a whole (macro-prudential regulation). Macro-prudential supervision will be one of the key innovations to emerge from the crisis.

A major overhaul of financial regulation is in prospect, both in the Anglosphere and Europe. It will not involve the supposedly unregulated Anglo-Saxon systems converging on existing European models, but Anglo-Saxon and European models converging on an entirely new model, with novel rules and institutional structures. Will the new system regulate future crises out of existence? Almost certainly not. Financial systems will always be prone to periodic crises because of the nature of their function – borrowing short and lending long – and because they rely on fickle human traits such as confidence and trust. But if the new system can limit the scale of future crises, it will have done its job.

Philip Whyte is a senior research fellow at the Centre for European Reform.

Wednesday, April 08, 2009

Towards a better EU migration policy

by Hugo Brady

Over the last decade, EU countries have experienced a rapid rise in both legal and illegal migration, mostly from Turkey, Morocco, Albania, Algeria and Serbia. Each spring and summer, Mediterranean member-states struggle to cope as migrants perish attempting to reach Europe from North Africa in unseaworthy and over-crowded boats. The deaths of 300 people, who drowned while trying to reach Italy from Libya, marked a particularly grim beginning to this year’s ‘smuggling season’.

Unsurprisingly, then, migration has supplanted terrorism and crime as the top priority for European interior ministers. Ministers think that collective EU action is essential if migration is to be managed better. That includes making European border management more effective and technologically advanced; integrating migration issues – visas, border controls, the resettlement of refugees and the return of illegal immigrants – into EU foreign policy; and helping Europe to fill the 50 million skilled vacancies that Europe’s retiring baby boomers will leave behind by 2060.

European policies to tackle these challenges are in their infancy, such as the Union's rather weak scheme to attract more skilled workers with an EU working visa or 'blue card'. One reason for this is that ministers have to work around major knowledge gaps about the specific foreign labour needs of the single market and about the movement of migrants into and around the EU, a free movement area. Governments have little idea where migrants go next after entering the UK from Pakistan, Spain from Ecuador or Poland from Brazil. For example, how many move to other EU countries; how many go back home; and how many are granted residency? Similarly, policy-makers are not yet certain about how good the EU’s border controls are. How many visas to the EU’s passport-free area result in illegal overstays or how many travellers are allowed in, refused at the border or returned home? Officials say they need to properly understand such movements before they can agree serious migration policies.

In many cases, such data is available but the patterns have not yet been analysed to draw concrete conclusions. The European Commission, which might be expected to have such information readily to hand, is over-burdened. Its directorate-general dealing with migration issues also has a plethora of other responsibilities, ranging from commercial law to terrorism. To overcome this lack of analytical capability, Commission officials often emphasise technological solutions such as biometric databases for visas and law enforcement. But these have tended to be subject to long development delays and will not, in any case, cut out the need to synthesise vast amounts of information.

One idea to help address such knowledge gaps would be to create national ‘immigration profiles’. The idea – already floated by the Commission – would be to maintain a precise and detailed picture of migration and border management in each member-state at any given moment. The Commission would also be able to ascertain the foreign labour needs of each member-state, by identifying skill shortages by sector and occupation, though member-states would still control the issuance of work visas. Similar profiles of non-EU countries could help identify the skills composition of different migrant communities and to provide analysis to EU policy-makers negotiating with migrants’ home governments on visa facilitation, border controls and the return of illegal immigrants. The member-states think that the EU speaking with one voice in such negotiations would be a significant improvement on national efforts.

The compilation of national immigration profiles is not a panacea for solving all of Europe's migration challenges. But if implemented effectively, the profiles could help to ensure that future migration policies are properly evidence-based and, therefore, more effective. However, if the Commission wants the job of providing such analysis, it will need to create a separate department for migration or to boost the resources of its current directorate-general for justice, liberty and security.

Hugo Brady is a research fellow at the Centre for European Reform.

Friday, April 03, 2009

The G20 summit – a distraction?

By Simon Tilford

The good news first. The summit delivered more than expected. The trebling of the funds available to the IMF goes well beyond anything expected and is very welcome. From a European perspective it increases the likelihood of further crises in central and Eastern Europe being handled through the IMF, rather than the EU having to get involved in the politically fraught business of setting conditionality. A renewed commitment to resist protectionism, together with an additional $250 billion for trade finance and $250 billion in special drawing rights are positive moves, as is the agreement to use the proceeds from IMF gold sales to help the poorest countries.

The agreements to extend financial regulation to all systemically important financial institutions and to establish a Financial Stability Board (FSB) to replace the existing Financial Stability Forum (FSF) also represent progress. The FSB will include FSF members along with G20 countries that are not FSF members, Spain and the European Commission. It will be in charge of identifying systemic risks and will collaborate with the IMF to provide an early warning system for future crises. The FSB will also implement FSF principles on bankers' pay and insure appropriate capital adequacy ratios. The deal represents a necessary democratisation of the international financial system.

Now the bad news. The agreement does little to address the immediate challenges facing the global economy – dealing with toxic debt and the contraction of aggregate demand. In this respect, the summit and the grandiose statements accompanying it were probably a distraction. There is little in the agreement that will help "restore confidence, growth and jobs" or "repair the financial system and restore lending", as claimed by the summit communiqué. Over time, the agreement might help to “strengthen financial regulation and rebuild trust” and could help to ‘prevent future crises’. But it is unlikely to help "overcome this crisis."

The absence of additional national measures to stimulate demand comes as no surprise, but it is no less disappointing. Perhaps the most important moment at the summit was when President Obama reminded the world that it can no longer expect the US to provide a disproportionate share of the growth in global demand. While condemning the US for its profligacy and talking about the advent of a fairer, more multilateral world, many countries seem to be relying on the US continuing to perform the role of 'consumer of last report'. This is either hypocritical or parochial or both.

Across much of Europe, the summit agreement is being portrayed as victory over the 'Anglo-Saxons'. This is rather puzzling. The agreement will not lessen the economic crisis facing Europe. Listening to French and German criticism of US proposals for a co-ordinated stimulus, anyone would be forgiven for thinking that the US would have had most to gain from such a package. In fact, the countries that stand to lose most from the collapse in global trade and the prospect of several years of exceptionally weak growth in global demand are the countries running big trade surpluses. The Japanese understand this and the need for stimulus; the German government does not. Europe as a whole will pay the price.

Similarly, the G20 agreement will do very little to address the problem of frozen credit markets. The Europeans are right to stress that strengthened regulatory oversight will be needed in order to put the financial sector on a more stable long-term footing. Indeed, everyone recognises this. But the more immediate problem is dealing with toxic debt. Agreeing to tighten regulation once the recession is over will not persuade financial institutions to lend now. The agreement to "provide significant and comprehensive support to our banking systems to provide liquidity, recapitalise financial institutions, and access address decisively the problem of impaired assets" means little. Too many European governments remain in denial over the extent of the problem, and will not take the necessary action to remove toxic debt from their banking systems.

The deal will not prevent the economic slump in Europe from deepening. This will lead to the further weakening of public finances that many European governments are anxious to prevent. Moreover, even the strengthening of multilateral control over the global financial system might have unintended consequences for some European countries. One systemic risk the FSB is almost certain to flag up is the persistence of huge, structural current account deficits, and the destabilising impact these have on the global financial system. A more regulated global financial system will involve more obligations for the big surplus countries, such as Germany.

Simon Tilford is chief economist at the Centre for European Reform

Wednesday, April 01, 2009

The Europeans at the London summit

by Katinka Barysch

Christine Lagarde, the French finance minister, threatens to walk out of the London G20 summit unless France gets its way on tougher financial regulation. The toppled Czech Prime Minister, Mirek Topolanek, who happens to hold the EU presidency, describes the US fiscal stimulus as “the road to hell”. Not one EU leader deems it necessary to support Gordon Brown publicly when he tries to drum up support for a more concerted international effort to revive the global economy. The Dutch and the Spaniards are turning the G20 itself into a misnomer by insisting on their own place at the table, and raising the number of the already over-represented Europeans (The fact that there will be six European governments represented, plus the Czech presidency, plus the European Commission, not counting the European heads of the World Trade Organisation and the International Monetary Fund, attracts deserved ridicule from other countries).

So is the G20 just another opportunity for the Europeans to show how weak, divided and status-conscious they are?

In fact, the Europeans have not done as badly in the run-up to the summit as some media reports (and occasional outbursts by stressed prime ministers) suggest.

EU leaders managed to thrash out a reasonably coherent position at their spring summit on 20th -21st March. The meeting’s final communiqué has a special section on the agreed line for the London summit. The words in this section are vague but represent a workable compromise which could allow the Europeans to speak with one voice at the G20.

G20 finance ministers had already reached a kind of truce on the issue of more fiscal stimuli at their meeting on March 14th. Not surprisingly, EU leaders, at their spring summit a week later, also rejected calls for an immediate increase in budgetary spending. So why some commentators are still speculating whether the G20 may come up with a new, co-ordinated package is a bit of a mystery. There needs to be a firm pledge from all G20 countries to assess critically the fiscal efforts they have made so far, and then to revisit the issue of a co-ordinated stimulus at their next summit, probably later this year.

At the March 20th–21st summit, EU leaders called only for swift implementation of those packages already announced. This, and the fact that the communiqué also calls on the EU countries to prepare for “an orderly reversal of macro-economic stimuli” and to “ensure consistency with longer term objectives such as sustainable public finances” represents a victory for Berlin and other capitals worried about inflationary pressures and the stability of the euro.

The Europeans supported global efforts to make more money available for the poorer and more vulnerable countries around the world. They started at home, by doubling the size of the EU’s own emergency fund for Central and Eastern Europe to €50 billion. The Europeans also agreed to raise an additional €75 billion as their contribution to a significant increase in the IMF’s war chest, to at least $500 billion. Since Japan had already pledged $100 billion, the onus is now on the US and China to chip in.

China, of course, will be cautious about committing money to an unreformed IMF. Here the EU’s position is lame. The communiqué only calls for a “reform of the IMF so that it reflects more adequately relative economic weights in the world economy”. The Europeans should have made it clearer that they are prepared to decrease their own voting shares and representation on the IMF’s management board. But diplomats say that the strongest opposition to thorough IMF reforms currently comes from the US – reluctant to give up its de facto ability to veto IMF decisions – rather than Europe.

On financial market regulation, the EU’s position is quite far advanced, much more so than the American one. The EU summit communiqué list all the measures that the EU wants to take – on regulating credit agencies, hedge funds, credit default swaps and so forth – and attaches deadlines to each. There has been a great deal of convergence within Europe, chiefly between Germany, France and others that want to see tighter rules and supervision of financial markets, and the UK, which has abandoned its belief in ‘light touch’ regulation. There are a lot of similarities between the recommendations of the recent reports from Jacques de Larosiere, which the EU wants to use as a basis for its legislative programme, and Adair Turner, head of the UK’s Financial Services Authority. Both, for example, call for more co-ordination between the supervision of individual banks and the monitoring of the stability of the financial system as a whole. The emerging US position as presented by US Treasury Secretary Timothy Geithner on March 26th also calls for more centralised supervision of US financial services, as well as a reform of capital adequacy and accountancy rules (in line with EU demands). Geithner for the first time acknowledged that hedge funds and other hitherto lightly regulated but systemically important finance vehicles need at least some supervision.

Of course the devil is in the detail and the London summit cannot and will not agree on more than the broad principles of further regulation and supervision. The debate about a new supervisory system in the US is only just beginning. It will be long and politicised. The EU’s deadlines for new legislation run from May until the end of 2009. Since the European Parliament will be re-elected in June and the European Commission will step down in October (although it could be extended to the end of the year), comprehensive new rules are unlikely before 2010.

The EU has looked weak and divided in the run-up to the G20 summit. Its reluctance to make more commitments to increase fiscal stimuli is rightly open to criticism. But the Europeans have actually managed to agree a reasonably coherent position and in many respects, their positions are as, or more, polished than the US ones.

Katinka Barysch is deputy director of the Centre for European Reform.