While the focus in Washington this week is on the forensics of Goldman Sachs’ actions during the financial crisis, and the outlook for domestic financial regulatory reform legislation, scant attention has been paid to the need for reforms to bring greater safety and stability to the global financial system.
It’s ironic that the push for financial reform has been so inwardly focused. If the financial crisis taught us anything, it was that our global financial system isn’t just bigger than ever before; it is far more interconnected than ever before – and destined to become more connected. Reforms that focus solely on reforms at the national level are destined to fail, and will only make future crises more – not less -- likely.
Most narratives point to the failure of Bear Stearns in March of 2008 as marking start of the financial crisis, forgetting some of the early chapters in the history of the crisis. In September of 2007 the UK’s Northern Rock first received liquidity support from the Bank of England, and was effectively nationalized a month before the Bear Stearns failure. The Netherlands’ Fortis Bank lost its footing early, as did the German bank, IKB – one of the most heavily regulated banks in the world. In fact, the list of highly-regulated European and British banks that stumbled early in the crisis is a long one. And we shouldn’t forget that AIG was brought down by the risky operations of its Financial Products division – a unit located not on Wall Street, but in London.
Global cross-border capital flows – both commercial and official – have exploded over the past two decades, with the value of daily transactions measured in trillions of dollars – and the value of the world’s outstanding bonds, equities, and banking assets is estimated to be measured in the hundreds of trillions of dollars. And these levels will continue to grow in future decades as emerging market economies become wealthier and more developed.
The global financial system doesn’t need a global systemic regulator – as some in Europe have advocated, but it does cry out for better coordinated, common standards for all globally active financial institutions on the appropriate levels of capital, liquidity, and leverage. Addressing these issues – as Treasury Secretary Geithner, to his credit, has advocated – will bring the most benefit to ensuring that our financial institutions are operating safely. These are the most important issues, and by a wide margin.
By comparison, the current debates in Washington over a consumer financial protection agency or resolution authority are sideshows. And absent global reforms, Congressional overreach in attempting to reform derivatives and proprietary trading in the U.S. are dangerous if they lead to shifting more transactions offshore to less regulated markets.
Getting global agreements on capital sounds easy, but it will be tripped up by conflicting views between Washington and Europe (and other financial capitals) about the appropriate accounting treatment of capital and the right levels. While Secretary Geithner and the G20 finance ministers have set the end of 2010 as a deadline for resolving these issues, it’s most likely that the U.S. will pass financial reform legislation this summer, while global reform will languish over longstanding disputes on these core issues.
The Financial Stability Board, headed by Italian central bank president Mario Draghi, has been given the authority to lead efforts achieve global standards for financial institutions. Draghi is exceptionally talented, but getting global agreement on these issues is daunting, and will become more difficult as nations put in place their own reforms.
Hitting the target just right at the global level is complicated. If not well-coordinated, it risks creating the conditions for “beggar thy neighbor” regulatory policies, or standards set so high that we squeeze necessary intermediation and risk taking out of the financial industry.
Already fault lines can be seen among nations like Canada and Japan who believe their institutions were not part of the problem and so shouldn’t be “penalized”; and also the US and the UK having different views on capital from continental Europe.
This much is clear: if the push for global standards loses momentum expect the next crisis to find its source in efforts to evade the hodge-podge of domestic reforms currently being discussed in Washington and Brussels.
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Tony Fratto, a CNBC contributor, is Managing Director of Hamilton Place Strategies – a strategic economic policy and communications firm based in Washington, DC. He is a former White House Deputy Press Secretary for the George W. Bush Administration and Assistant Secretary of the Treasury. You can follow him on Twitter at http://twitter.com/TonyFratto.