Five Ways to Fix Our Financial Architecture

By Howard Davies, director of the London School of Economics. He has served as deputy governor of the Bank of England (THE WASHINGTON POST, 23/10/08):

Some urgent reforms need to be made to the architecture of international financial regulation, but talk of a second Bretton Woods conference is misleading. Neither the International Monetary Fund nor the World Bank is a financial regulator in the sense of being a body that sets the rules for and supervises individual institutions. Those important tasks are carried out by less glamorous entities such as the Basel Committee and the International Organization of Securities Commissions. The real issues relate to the way in which these bodies carry out their jobs.

As government leaders grapple with the flaws in those processes, they need to keep five objectives in mind:

First, we need a simpler set of mechanisms that better reflect the shape of today’s markets. In a book on regulatory architecture published this year, David Green and I tried to describe the existing structures. They are impenetrably complex. When I became chairman of the United Kingdom’s Financial Services Authority in 1997, the authority — Britain’s only financial regulator — was a member of about 75 international bodies or committees. By the time I left in 2003, that number had doubled. One problem is that the global financial system is built in three silos: banking, securities and insurance. That structure no longer reflects reality. We know that risks are transferred between these silos and that insurance companies and brokers can pose systemic risk. We need simpler structures, with cross-sectoral coverage.

Second, there is a big problem of legitimacy. The Financial Stability Forum, which sits at the center of the system (without much formal authority), includes the Netherlands and Australia but not China or India. Ten of the 13 members of the Basel Committee, which sets bank capital ratios, are from Europe; there is only one Asian member. The crisis presents a good opportunity to make these bodies more representative. If we do not allow China to participate in making the rules governing finance, how can we expect it to obey them?

Third, the new system needs to move faster. It took the Basel Committee the better part of a decade to design the Basel II standards that banks are just beginning to implement. That’s right: These guidelines on leverage and capital are already out of date before coming into service. Regulatory clocks must be speeded up.

Fourth, and most crucial, we need to build a new link between macroeconomic surveillance and regulation. That is where the IMF comes in. Looking back over the past decade, it is easy to find warnings of trouble ahead. The IMF’s global financial stability reports included dark alarms about the unwinding of imbalances. The Bank for International Settlements has a better record, regularly pointing to asset price bubbles and systematic risk mispricing. But those warnings did not feed through into the setting of bank capital requirements. Such connections need to be made. We also need a mechanism that can induce banks to hold more capital in boom times, which would help to restrain the expansion and provide a softer cushion if and when prices begin to fall, and take other countercyclical precautions. In other words, if asset prices or risk spreads diverge significantly from their long-term trends, supervisors would impose an across-the-board capital supplement to reflect the potential cost to the banks of a subsequent decline in prices.

Lastly, there is a need for new and sustained political leadership. The Group of Seven concerns itself with regulation only at times of crisis. For example, the Financial Stability Forum was created after the Asian crisis of the late 1990s, and then the finance ministers all but forgot about it until the end of last year. Perhaps a standing subcommittee of the G-7 could be given a permanent role overseeing financial regulation, with the FSF as its arms and legs. The forum is the only place where regulators meet central bankers, finance ministry officials and representatives of the international financial institutions. It brings all the right people together in a room. It should be renamed the Financial Stability Council, given a proper staff and empowered to give instructions to the sectoral regulators. If the G-7 ministers want this to happen, it can.

Of course, better architecture is just the first step. Difficult problems such as how much capital is needed in the system and how to regulate liquidity remain to be solved. We need to grapple with unregulated firms and with the “black holes” of offshore centers. And in some countries, notably the United States, there is a desperate need for change in the domestic financial system.

These issues present enough material for several summits. President Bush will not be there to see how this story plays out, but his successor will surely be spending much time with Nicolas Sarkozy and Gordon Brown.