Tuesday, September 1, 2009

Have the banking weaknesses exposed by the financial crisis been adequately addressed?

I am not confident at all that we have moved to the type of regulatory environment that is necessary to prevent the next crisis. I tend to agree with the IMF assessment that our model of financial regulation was deeply flawed. Loan brokers and mortgage originators had few incentives to more realistically assess risk which, in any case, they sold on to others—this was part of the “financial innovations” so warmly welcomed by market participants. Investors relied too unthinkingly, in assessing asset quality, on unrealistic or overly optimistic analyses done by credit rating agencies, which, again, proved a time-tested ability to be lagging indicators of crises (remember the 1997 Asian financial crisis?). Regulation and supervision were too concentrated on firms and not sufficiently focused on issues of systemic risk. None of these weaknesses is being addressed in a credible way yet.

The shadow banking system—investment banks, mortgage brokers, hedge funds, among others—were lightly regulated by a multitude of agencies. The assumption was that only deposit-taking institutions needed to be regulated and supervised, thereby encouraging financial innovation in the rest of the system which, the thinking went, would act under a regime of self-imposed market discipline, spurred by the self-correcting nature of financial markets. Obviously the system had a huge amount of moral hazard built in which, regrettably, the financial crisis has not eliminated. Excellent results in some financial institutions in recent quarters—and levels of compensation that in many cases are no worse than those last seen in 2007—are partly the result of risk profiles fuelled by public funds.

We need to move to a system where, as noted by the IMF in its latest World Economic Outlook, “all activities that pose economy-wide risks are covered and known to a systemic stability regulator with wide powers.” This would include banks, institutions issuing CDOs attached to mortgages or insurance companies selling credit default swaps. Disclosure obligations within this “extended perimeter” should then allow the supervisory authorities to determine relative contributions to systemic risk and to calibrate the scope of the prudential oversight needed. For instance, one would discourage the emergence of mega-banks. The financial system has become too concentrated. Over the past 20 years, the share of US financial assets held by the 10 largest US financial institutions has risen from 10 percent to 50 percent. This is not desirable and, not surprisingly, has led to calls for change—Chancellor Angela Merkel recently stated that “no bank should be allowed to become so big that it can blackmail governments”—a thoroughly sensible proposition. One way to achieve this is to simply force very large financial conglomerates to spin off assets, although there is also merit in proposals to do this via capital ratios that rise with the contribution to systemic risk. Indeed, many of the recommendations put forth by the IMF in the aftermath of the crisis are quite sensible, but we are not moving anywhere near fast enough to implement them. In particular, there seems to be a reluctance to address the issue of institutions that “are too big to fail” and the moral hazard that they imply. As expected, vested interests are working full time to prevent the implementation of such reform proposals. Paul Krugman is certainly correct in lamenting the extent to which vested interest (or, as he puts it, “corporate cash”) has “degraded our political system’s ability to deal with real problems.” But there are other problems as well, beyond vested interests. Alan Blinder from Princeton alludes to our “amazing capacity to forget” (the crisis was last year’s problem), an overcrowded legislative agenda in the US, bureaucratic infighting in connection with the rearrangement of supervisory responsibilities which the reforms would imply, and the fact that it is difficult to get the public excited about banking regulation, as dry and arcane a subject as there is.

The IMF also thinks that it would be desirable to mitigate pro-cyclical behavior, for instance by raising minimum capital requirements during upswings (when, in the US, the Federal Reserve has tended historically to take a hands-off approach) and allowing these to come down in a downturn, when, again, the Federal Reserve in the US has tended to be aggressive in loosening monetary policy. Many think that one could do the same for leverage—introduce a supplementary leverage ratio for banks. There is also a need to reform the system of incentives for compensation, which remain perverse and, at the moment, are rewarding many players in the financial system, as noted above, for assuming risk with public funds. It would also be desirable to sever or, in any case, weaken the connection between compensation and annual results and link it more to medium-term return on assets. An interesting question is whether it was a terrible mistake to have repealed in the United States the Glass-Seagall Act which separated commercial from investment banking. I am very sympathetic to the idea that in the financial system household deposits (which are insured) should only be invested in low-risk assets, which is not what we had at the outset of this crisis, when deposits were being used in high-risk activities.

Central banks need to broaden their definition of “financial stability” from an often exclusive concern with stabilizing inflation to looking at asset price increases, credit booms, leverage and ways in which financial innovations might be complicating the task of the authorities in setting monetary policy—you know you are in trouble when some instruments are so complicated that you no longer can tell whether they should be included in the definition of some appropriately broad monetary aggregate. The IMF is right when they say that it matters a great deal whether the boom is associated with high leverage. For instance, the dotcom bubble of the late 1990s was associated with limited leverage and thus its bursting had limited impact on economic growth. In the current crisis, asset price collapses have greatly affected the balance sheets of financial institutions.

However, there are several other issues, beyond purely aspects of the new regulatory regime that needs to be brought into being, which are a source of concern. I would like to highlight several. First, there is the question of fiscal sustainability.

There are several reasons why we should worry about the remarkable increases in public debt underway. One has to do with the constraints on government policy which high levels of debt normally imply. With debt levels in excess of 100 percent of GDP, governments are less able to invest in education, infrastructure and other productivity-enhancing areas, to say nothing of moving to a lower-tax environment. This undermines growth. High debt service becomes an important constraint on the ability of governments to respond to pressing social and other needs, including possibly responding to other unforeseen crises in the future.

Second, in a large number of the bigger economies there are unfavorable demographic trends which are resulting in the aging of populations. Increases in life expectancy combined with declining fertility will have systemic implications for the sustainability of pension systems, the ability of governments to remain faithful to the key elements of the social contract.

In fact, governments are having a tough time in getting the thrust of policies right. On the one hand, there has been and there may well continue to be a need for fiscal stimulus, to mitigate the effects of the recession. On the other hand, too much fiscal stimulus risks undermining government credibility, as debt levels are perceived by markets to be unsustainable; by 2014 many rich industrial countries will have debt levels on a par with Italy’s, an inevitable consequence of the bountiful flow of red ink everywhere. Particularly worrying is a scenario where foreigners become concerned that higher government financing would push up long-term US bond yields, leading them to want to reduce their exposure which would then put strong pressures on the dollar. One way to deal with this tension is to be judicious in the choice of stimulus measures. For instance, governments should target measures that bring long-term benefits to the economy’s productive potential—infrastructure spending is very helpful but I think that the crisis has also given us a great opportunity to spend more money for environmental protection and conservation. This might be an ideal time to introduce carbon taxes, to move a little closer to a world of full-cost pricing, which we are not doing by largely ignoring some of the more deleterious effects of global warming.

Third, we need to address fiscal challenges posed by aging populations. What does this mean? Let’s take the case of Europe. Solidarity and social cohesion are very much at the center of European policy debates. One element of the solution will be to work longer and retire later. We must, therefore, boost training of the workforce, to extend the useful productive life of workers, perhaps in increasingly flexible settings. This, in turn, will force governments to reconsider expenditure priorities with a view to making resources available for re-training. This is a key element of better management of the globalization process.

We must also deal more effectively with global imbalances. This is a reference to large current account deficits and surpluses in countries such as the US, Japan, Germany, China, which, under some scenarios, could cause a reversal of capital inflows into the US and cause a massive drop of the dollar. Massive capital inflows have been associated with excessive risk taking, exchange rate risk and other sources of systemic risk. I have done some quick calculations which show that the current account deficits of the US, the UK and Spain (a combined $909 billion in 2008) are just offset by the current account surpluses of Germany, Japan, China, Switzerland, Norway and the Netherlands ($903 billion).

But this is largely a US, China, Japan and Germany phenomenon, as the surpluses of these last 3 countries account for about 112 percent of the US deficit. These imbalances have been a huge source of risk to the global economy. Among the causes: structural high savings in China linked to the fact that in this country there are no effective mechanisms of social protection, no pensions, no unemployment protection. The large Chinese population saves for old age because of lack of mechanisms of social protection; in the presence of such a system surely they would have a higher demand for American and European consumer goods, which would bring their 9.5 percent of GDP trade surplus down.

In any event, it is evident that we need to have more effective mechanisms of international coordination to deal with the global nature of the crisis and ensure that we do not go back to a world of destructive protectionism.

Monday, May 4, 2009

Nominate Nine Wise Men and Women to Restore IMF's Credibility

Published on the Editorial Page of Financial Times, May 4, 2009

Letter to the Editor

Dear Sir/Madame,

The London Summit of the G20 went some ways toward strengthening the capacity of the IMF to assist emerging markets currently suffering the spill-over effects of the financial crisis. The Summit seems to have been less successful in updating the governance structure of the IMF, to better reflect the changes which have taken place in the structure of the global economy during the past quarter century. Thus, at least until 2011 (maybe even longer), IMF decisions will continue to be made in an absurd system where the voting power of the EU currently stands at 32.4 percent, whereas the combined voting power of the United States, China, India, Brazil and Russia—accounting for a much larger share of global GDP—is 26.9 percent. The G20 also decided to finally break, at least nominally, with the convention adhered to ever since the IMF’s creation, which establishes that its managing director (MD) must be an EU citizen. Like the current permanent membership in the UN Security Council, this practice is an aberration and should have been abandoned long ago.

Despite the important symbolism of the G20’s decision, we think that the new system is not likely to be much better and there is a significant risk that it might actually be worse. The main risk is that we will now move to the system in place at the UN, where the Secretary General is chosen, de facto, on a rotating basis, from different regions of the world. The problem with that system is that it tends toward the lowest acceptable common denominator, with the top job going to someone who is palatable to all constituencies—a process which on occasion can lead to mediocrity or worse.

We have a humble proposal. Let’s do away with the job of the MD and replace it with a Supreme Management Council, a group of 9 wise men and women appointed for life (or until a suitable retirement age). Think of all the benefits. First, they would not be beholden to the interests of the richer members and would operate with independence of mind and the interests of the international community at heart. Second, as members retired they would be replaced with younger blood and the Council would thus become a repository of decades of relevant experience on the issues that matter for management of the global economy. Contrast this with the present system where each new MD has to spend a couple of years catching up before the pressures of work or other factors tempt them to bail out. Both Messrs Kohler and Rato—the two preceding MDs—left before the expiration of their 5-year terms. Nine members working in a spirit of consultation, not worried about the length of their tenure on the job would surely bring more mental firepower to the job than a sole individual, verily coping with the pressures of the moment. Unanimous decisions would be favoured but, as needed, majority voting would do. Instead of having central bank governors and finance ministers nominate their own favourite peers, the Council could be filled via international recruitment. Let able and experienced individuals apply for the jobs and let the Fund’s governors vote on the best candidates. An open, transparent, meritocratic, democratic form of governance, seeing to the interests of the entire membership would greatly improve on the status quo, since all these qualities are lacking in the current system, even in the aftermath of the G20 London Summit. Such a system would go a long way toward strengthening the much diminished credibility of the IMF, at a time when that scarce asset is most in need.

Jorge Castañeda
Foreign Minister of Mexico (2000-2003)
Global Distinguished Professor
New York University

Augusto López-Claros
Director, EFD–Global Consulting Network

Thursday, April 9, 2009

Was the G20 London Summit a Success?

Augusto Lopez-Claros1

Whether to view the G20 London Summit as a success or as a disappointment is very much a function of one’s reference point.2 Viewed against the needs of the moment—a global economic crisis without parallel since the Great Depression—it could be argued that the Summit did not go far enough. The fact is that in the past 30 years the global economy has become both more complex and more interconnected, but the mechanisms and institutions that we have to deal with crises have not kept pace with the tempo of change and what has emerged is a “governance gap”. An inability to cope with complex global problems either because the institutions we have are woefully unprepared or, in some cases, because we do not even have an institution with the relevant jurisdiction to address the problem in question (e.g. climate change). Against these challenges the Summit’s achievements—a combination of well-meaning declarations and a few hard decisions—were at best a mixed bag.

On the positive side, it is no doubt an achievement of sorts to have brought into the decision making some of the larger emerging markets. The G7, accounting for 11 percent of the world’s population, was clearly not a broad enough forum. The G7 was originally created to discuss “major economic and political issues facing their domestic societies and the international community as a whole.” In time, it became a good forum for open debate about global problems, but not a particularly effective problem-solving vehicle. In the public imagination, its semi-annual meetings were largely perceived rather as excellent photo opportunities, not as brain-storming sessions focused on particular problems requiring urgent solutions as was, for instance, the 1944 Bretton Woods conference which lasted 22 days, involved over 700 delegates from more than 40 countries, and resulted in the creation of a new world financial system, G7 meetings are actually intended—as noted by a former G7 prime minister—to preserve the status quo. The creation of the G20 in 1999 was seen as recognition of the new economic and political realities, but neither the Swiss nor the Dutch nor the Spanish were particularly happy at being excluded. Switzerland manages a third of the world’s private wealth and the Netherlands is the most generous donor and, by far, the country with the most development-friendly policies. Spain, a country whose economy is more than 5 times the size of Argentina’s (a member of the G20!), took great exception to being excluded from the November 2008 G20 Summit—only strenuous lobbying delivered a last-minute invitation.

Of course, both the G7 and the G20 remain, in fact, official bodies. Their deliberations bring to the table heads of state and a small coterie of civil servants. There is no representation from the business community, nor do civil society representatives participate. Given the global nature of the problems we face and the increasingly shared perception that solutions to these will require broad-based collaboration across various stakeholder groups, for many, these groups still suffer from a deficit of legitimacy. They are not a fair representation of humanity and, as such, cannot be expected to make any important decisions on its behalf. There are no low income countries among the G20—their voices simply do not count. Despite these flaws, some progress was made in London and I would like to focus on those that pertain to the International Monetary Fund.

During much of the past decade the IMF has found itself in the middle of virtually all major emerging market crises and questions about its effectiveness have been raised; indeed some have argued that the organization is no longer needed in a world of largely floating exchange rates. It is clear, however, that with fully globalized financial markets and in which policy missteps in one country have costly spillover effects on others (as we have seen over the past year), an institution that will have sufficient resources to deal with episodes of financial instability and that will help cushion or prevent the effects of future crises is indispensable.

Like a central bank the IMF can create international liquidity through its lending operations and the occasional allocations to its members of SDRs, its composite currency. The IMF already is, thus, in a limited sense, a small international bank of issue. As seen during much of the past decade and a half, the Fund can also play the role of “lender of last resort” for an economy experiencing debt-servicing difficulties. But the amount of support it can provide has traditionally been limited by the size of the country’s membership quota and there is an upper limit on total available resources; as of early-2009 this amounted to about $250 billion, a puny amount when compared with the sorts of sums that are necessary to intervene in industrial countries in distress or even some of the larger emerging markets.

There are a number of ways to deal with these funding shortfalls. One proposal some years back was to create a Financial Stability Fund, to supplement IMF resources. This would be a facility that could be financed by an annual fee on the stock of cross-border investment; a 0.1% tax could generate some $25-30 billion per year, which could then be used over time to create a $300 billion facility. An alternative and more promising proposal would give the Fund the authority to create SDRs as needed, as a national central bank can in theory, to meet calls on it by would-be borrowers. When this idea was first put forward, in the early 1980s, concerns were raised about the possibly inflationary implications of such liquidity injections, but international inflation was a serious problem then in ways that, in the midst of a global recession, it is clearly not one today and measures could be introduced to safeguard against this.

The London Summit went some ways toward strengthening the capacity of the IMF to play a supportive role to emerging markets currently suffering the effects of the international financial crisis. This was achieved mainly by significantly expanding the resources available to the organization under special borrowing arrangements negotiated with a few central banks and by allowing a $250 billion SDR issue. The Summit seems to have been less successful in moving more quickly to update the voting power of its member countries, to better reflect the changes which have taken place in the structure of the global economy during the past quarter century. Slowly and grudgingly, kicking and screaming, EU members finally appear to be coming around to recognize the absurdity of a system where the voting power of the EU currently stands at 32.4 percent, whereas the combined voting power of the United States, China, India, Brazil and Russia, accounting for about half of the world’s population is 26.9 percent, though, collectively, these countries account for a much larger share of global GDP. This distribution of power leads to such anomalies as Belgium having a larger quota than India and China having a quota only marginally higher than Italy’s and well below that of France, facts which have undermined the institution’s credibility. Not surprisingly, Asian countries do not see they have a stake in empowering the IMF, regarding it increasingly as embodying power relationships which no longer reflect contemporary economic and political realities. An IMF without credibility, of course, is of no use to the international community, particularly at a time of global crises. That these so-called “voice reforms” have to wait until 2011 is a good indicator of the enormous inertia which has to be overcome to modernize our sclerotic global institutions, at a time when it is of the utmost urgency to strengthen mechanisms of international cooperation.

Also welcome was the decision to finally break with the convention adhered to ever since the IMF’s creation, which establishes that it’s managing director (MD) must be an EU citizen.3 Like the veto power in the UN Security Council this practice is an aberration and should have been done away with long ago. It is, in fact, surprising that this practice has persisted for so long given that whereas IMF lending operations have no budgetary implications for members such as the US and the EU (indeed they earn a return on their SDR reserve assets), the salaries of the Fund’s MD and of its entire staff as well as all other administrative expenditures are entirely financed by the interest paid by borrowing countries. In other words: the IMF functions thanks to taxpayers in middle and low-income countries, not the rich countries who have run it since it was first founded.

Despite the important symbolism of the G20’s decision, efforts will have to be made not to allow the new system to turn into something actually worse. The main risk is that we could now move to the system in place at the UN, where the Secretary General is chosen, on a rotating basis, from different regions of the world. The problem with that system is that it tends to breed mediocrity, with the top job going to someone who is acceptable to all constituencies—a process which then leads to the lowest common denominator.

It remains an open question whether, in retrospect, the London Summit will be seen as a good starting point for a more multilateral approach to global problem solving. In my view the main risk we face at present does not stem from the financial crisis itself. Rather, the risk is that within a year the global economy will have entered a phase of recovery and governments will start feeling complacent again and, as I noted some months ago in a letter to the Financial Times, we will miss a once-in-a-life-time opportunity to address the serious vulnerabilities in the world’s financial system which the current crisis has revealed. The next crisis—most likely hitting us from some totally unforeseen corner—would find us with much higher levels of public debt and, therefore, far more constrained in our ability to respond to the emergencies at hand. Crises can be opportunities for urgent reforms, but they can also be wasted through lack of political will and imagination.


1. Augusto Lopez-Claros was IMF resident representative in Russia and chief economist of the World Economic Forum. In 2007 he was co-editor of The International Monetary System, the IMF, and the G-20: A Great Transformation in the Making? published by Palgrave Mcmillan.
2. For the record, the G20, in fact, is the G22 as it also includes Spain and the Netherlands, two countries originally excluded from membership.
3. A similar recommendation applies to the World Bank, whose president has traditionally been an U.S. citizen.