The G-20’s communiqué offered a surprisingly robust work program for regulatory reform. MIT’s Simon Johnson even worries that it may be too robust – and push banks to scale back their lending in a pro-cyclical way. I am a little less worried about this risk. I assume regulators recognize that a sensible macro-prudential regulatory framework requires raising capital charges in good times (to lean against the boom), not forcing banks to squeeze lending to conserve capital in bad times.
The G-20’s ability to reach agreement on a detailed work program on regulatory reform – just think, the US President has signed off on an effort to evaluate whether compensation practices in the financial sector contributed to excessive risk taking — presumably reflects the groundwork done by the Financial Stability Forum. Many of the G-20’s proposals reflect reforms that key countries have already agreed on there.*
It also reflects another reality: agreement on regulatory changes only required a deal among the G-7 countries, not a deal between the G-7 and the emerging world. The big internationally-active banks are still primarily in the US, Europe and Japan – and are still regulated (and bailed out) by these countries. Emerging economies of course feel the impact of a fall in lending if the financial sector in the US and Europe is hobbled – so they aren’t just bystanders. They should want the US and European regulators to do their jobs effectively, so they aren’t sideswiped by a sudden fall in lending. And no doubt regulation in the emerging world is influenced by practices in the US and Europe. But most emerging market banks already held a bit more capital than US or European banks, as the emerging world didn’t bet on the notion that the fall in macroeconomic and financial volatility associated with the “Great Moderation” was permanent. The Great Moderation never really made it to most of the emerging world: they had a lot more recent experience with macroeconomic volatility.
The “regulatory” deal consequently hinged far more on the US and Europe than the emerging world. And they stepped up. I was struck by how robust the G-20 language describing the short-comings in the advanced economies financial systems was. The G-20 leaders:
During a period of strong global growth, growing capital flows, and prolonged stability earlier this decade, market participants sought higher yields without an adequate appreciation of the risks and failed to exercise proper due diligence. At the same time, weak underwriting standards, unsound risk management practices, increasingly complex and opaque financial products, and consequent excessive leverage combined to create vulnerabilities in the system. Policy-makers, regulators and supervisors, in some advanced countries, did not adequately appreciate and address the risks building up in financial markets, keep pace with financial innovation, or take into account the systemic ramifications of domestic regulatory actions.
But I was also struck my how quiet the G-20 was on the macroeconomic imbalances that facilitated the expansion of leverage in the US and Europe. Remember, the US had a low savings rate – and required inflows from the rest of the world. If those inflows had fallen off as US household debts – and the financial sector’s balance sheet leverage – increased, the US might not have dug itself into a hole. The communiqué language here was remarkably diplomatic. No mention was made of macroeconomic imbalances across countries – or misaligned exchange rates. The communique language remained very vague: “Major underlying factors to the current situation were, among others, inconsistent and insufficiently coordinated macroeconomic policies, inadequate structural reforms, which led to unsustainable global macroeconomic outcomes.” I consequently am surprised (or perhaps I should say less than impressed) that the White House believes that the G-20 reached “a common understanding of the root causes of the global crisis.” Paulson was quite clear on Thursday that the macroeconomic imbalances the G-20 avoided mentioning had something to do with the current mess.
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