The Saturday meeting of the Group of Twenty nations should explore the idea of a new “world financial organization” (WFO) that, like the World Trade Organization (WTO), would blend national sovereignty with globally agreed rules on obligations for supervision and regulation.
It should agree to immediately boost the International Monetary Fund’s (IMF) lending capacity, with nations such as China contributing in exchange for a revamping of the old Group of Seven or Group of Eight (G-7/G-8) into a new G-7 (the US, the European Union (EU), Japan, China, Saudi Arabia, South Africa and Brazil) that would provide a global steering committee.
Now that the quashing of excessive expectations is complete, it’s time to ask what can realistically be accomplished by the heads of state meeting in Washington on Saturday.
Their central challenge is how to ensure comprehensive and consistent supervision and regulation of all systemically significant financial institutions, and cross-border financial institutions in particular. The crisis is a reminder that inadequate supervision at the national level can have global repercussions. Addressing this problem is the most important step to make the world a safer financial place.
There will be calls for a global regulator, echoing proposals for a world financial authority by John Eatwell and Lance Taylor a decade ago. But it’s unrealistic to imagine that the US and for that matter any country will turn over the conduct of national financial regulation to an international body.
The US has already signalled its position on this question. Regulation of financial markets is a valued national prerogative.
Not even EU member states have been willing to agree to a single regulator. In any case, the particularity of national financial structures places effective oversight beyond the grasp of any global body.
The European proposal for squaring this circle by creating a College of Regulators is weak soup. We need more than information sharing and discussions. It would be better to strive to create a WFO analogous to WTO. Countries seeking access to foreign markets for financial institutions they charter would have to become members of WFO.
They would have to meet the obligations for supervision and regulation set out in its charter and supplementary agreements. But how they do so would be up to them. This would permit regulation to be tailored to individual financial markets.
An independent body of experts, not unlike WTO’s dispute settlement panels, would then decide whether countries have met their obligations. A finding of lax implementation would have consequences. Specifically, other countries could prohibit banks chartered in countries found to be in violation from operating in their markets. This would protect them from the spillovers of poor regulation.
It would foster a political economy of compliance. Governments seeking market access for their banks would have an incentive to upgrade supervisory practice. Resident financial institutions desirous of operating abroad would be among those lobbying for the requisite reforms.
Sceptics will question whether countries such as the US would ever accept having an independent panel of experts declaring the US regulatory regime to be inadequate and authorizing sanctions. But this is just what WTO’s dispute settlement panel does in the case of trade. Why should finance be different?
Creation of a WFO is not a be-all and end-all. Trading in derivative securities should be moved onto an organized exchange to limit counterparty risk. Basel II should be urgently reformed to raise accepted measures of capital adequacy, reduce reliance on commercial credit ratings and banks’ models of value at risk, and add a simple leverage ratio. These steps can and should be taken relatively quickly. But commencing negotiations on a world financial authority would be the most important single step.
It would be preferable to create WFO as a new entity rather than building it on the platform of an existing institution such as IMF or the Financial Stability Forum (FSF). FSF is dominated by the G-7 and the various international organizations with only Hong Kong and Singapore as token “emerging market members”.
IMF has the advantage of universal membership, but its past capital market surveillance has not exactly covered it in glory. It continues to be regarded with suspicion in Asia and Latin America. Countries there would be reluctant to sign up to a world financial authority that was its wholly owned and operated subsidiary.
This brings us to the other key challenge that must be met to make the world a safer financial place: mobilizing resources, both financial and political, of emerging markets. IMF desperately needs additional funding to aid crisis economies, and governments such as China’s are the logical contributors. The question is what to give them in return.
It would be more effective for the US, Europe and Japan to agree to abandon the G-7 or G-8, which is no longer a suitable steering committee for the world economy, in favour of a new G-7 composed of the US, the EU, Japan, China, Saudi Arabia, South Africa and Brazil. This would not require negotiations among hundreds of countries stretching over years—time which is not available, given the urgency of the task. It would give China and the others a seat at a table that really matters. It would give them ownership and the sense that they have a stake in the stability of the global economy.
In addition, Europe could agree to a single executive director on the IMF board, freeing up directorships for emerging markets. Who better than a European leader such as Dominique Strauss-Kahn to announce that the leadership of IMF should be thrown open to the most qualified candidate regardless of nationality?
The author is the George C Pardee and Helen N Pardee professor of economics and professor of political science at the University of California, Berkeley. He is also a research fellow at the Centre for Economic Policy Research
Edited excerpts. Published with permission from VoxEU.org. Comments are welcome at firstname.lastname@example.org