When do we need global rules? And who should write them? This is a central issue for the G20 process.
In recent years, the UN, specialist technical agencies, and even the private sector have all played in this space. Now the Trans-Pacific Partnership (combined with the nascent Transatlantic Trade and Investment Partnership) represents another approach towards near-universal rules. Even so, the G20 remains the home of global rule making for the finance sector. After the 2008 financial crisis, it set about re-writing a good chunk of the regulation that had proved so inadequate. So how is this high profile attempt working out? It's fair to say the outcome on capital requirements, for example, is mixed while the whole exercise raises questions about appropriate priorities.
The process has been coordinated by the Financial Stability Board, a G20 offshoot working closely with the Bank for International Settlements, that established earlier global financial-sector rules. Those pre-2008 rules were clearly deficient. Banks and other financial institutions didn’t have enough capital to ride out the crisis. Voters were incensed that taxpayers’ funds had to be used to bail out the financial fat-cats.
Against this background, it is not surprising the key reform aim has been to increase capital requirements and thwart the widespread gaming of the old Basel Rules through which some banks (especially in Europe) operated with levels of capital that, we now know, were perilously skinny.
But there are clearly intrinsic constraints on effective global rule-making. In the immediate aftermath of the 2008 crisis, public anger generated strong political will for root-and-branch reform. But it takes time to sort out the technical details and Wall Street (and London’s ‘City’) have been quite successful in steering the rule-making to avoid damaging either their franchise or their bottom line. Delay is the deadliest form of denial, and, as public anger faded, the proposed rules have softened. One example of this is the voluminous Dodd-Frank Act, legislated in 2010 and since watered down in implementation regulation.
Meanwhile, the deep-seated risks inherent in the financial sector have gone largely unaddressed. [fold]
As 2008 demonstrated, the most damaging risks are not external events, such as a housing bubble, but the endogenous responses of market participants. A modest problem escalates when investors simultaneously attempt to strengthen their balance sheets. Risk management is uniform across the entire financial sector, so all market players respond the same way when a risk event arises and, with too many sellers and too few buyers, markets collapse. Prudential rules force banks to recapitalise at precisely the time when financial markets are unwilling to provide capital. Addressing these structural issues would require fundamental restructure of the financial sector. No one has the stomach for that.
The continuing focus on risk-weighted capital requirements means the system is still vulnerable. One of the key weaknesses exposed in 2008 was that, when the crisis came, bond holders were treated differently than anticipated. In theory, bond investors' funds were available to support failing banks but, when the crunch came, bond holders were repaid, just as if they were guaranteed depositors. Forcing bondholders to write off some of their debt, or 'bailing them in' as the jargon goes, would have been politically painful and might have started a contagious run on other financial institutions. It was easier to pay out the bond-holders, even though this shifted the burden of bank failure to the taxpayers. When Ireland’s largest banks failed in 2009 the bond-holders (mainly European banks) were left unscathed.
Despite the apparent lesson here, the higher capital requirements specified by new rules are achieved by designating exactly this sort of bailing-in process for some bond-holders. Why will it work any better in the future?
The resource-intensive complexity of the new rules also raises a more fundamental issue: do we really need uniform global rules in the financial sector? The rule makers have designed key parameters around the very largest banks (so-called Global Systemically Important Banks or G-SIBs), of which there are no more than a few dozen world-wide. Banks that are not G-SIBs require less capital, but the complexity of the approach is the same. Prudential regulators in all countries (including those with limited bureaucratic resources) will, as a matter of national pride, set their goal to implement the new rules, even though they may be designed for different circumstances than their own.
It would have been better to have explicitly stated that the 'global' rules should apply only to those banks that provide a threat to the global economy. Other regulators, (including most G20 countries) should have had had a much clearer brief to set their own, simpler versions, more appropriate to their circumstances. After all, competent domestic supervision will do far more to avoid crises than global rules.
So can we conclude this huge effort was a search for a solution to a problem that doesn’t need this high degree of global coordination? More importantly, are there higher-priority areas which do, in fact, require globally uniform rules?
Consider, for example, another G20 agenda item: company tax; or, in the jargon, base erosion and profit shifting. This is a live issue for Australia, given the vocal lobby for lowering company tax. Some of those advocating are, of course, motivated by the simple personal desire to pay less tax. But even disinterested observers who want to promote an effective tax system understand that capital is the most mobile of resources; profits will move to whatever country has the lowest tax rate.
Does this mobility endorse as inevitable the present position where many foreign multilateral companies pay little or no tax in Australia? At the risk of sounding naïve, there should be an alternative, where companies make a fair contribution to the costs of administering the economy in which profits are earned. But this can’t happen without global rules, rules that would have to navigate the different perspectives of large, foreign-investing countries and a capital importer like Australia.
We will need a good international process to get a fair outcome. If G20 can’t effectively address a problem like this, which unambiguously requires a global solution, we should question its relevance.