Financial regulation and the G20

Mike Callaghan[1]

This issue of the Monitor canvases the role of the G20 in strengthening financial regulation.

It contains articles by Hugh Jorgensen (Lowy Institute), Stephen Pickford (Chatham House), Richard Gray (Westpac), myself, Steven Bardy (Australian Securities and Investment Commission), Ross Buckley (University of New South Wales) and Graham Hodges (ANZ).

It also includes a summary of the discussion at a regional ‘Think 20’ seminar recently held at the Lowy Institute.

Financial regulation has been a central agenda item of the G20 since the first leaders’ summit in November 2008 and the topic has retained a prominent place in the communiqués from meetings of G20 leaders and finance ministers and central bank governors since then. The G20 transformed the Financial Stability Forum into the Financial Stability Board (FSB) and the FSB has pursued a wide range of financial sector reforms, with the backing of the G20.

The papers in this issue of the Monitor reflect a cross section of views on financial sector reform. The objective in compiling them is to contribute to determining what Australia’s approach to this topic should be when it chairs the G20 in 2014.

The extent of the reform agenda

The vast range of work in strengthening financial regulatory arrangements is extensively documented by the FSB, which provides a status report to G20 leaders and finance ministers prior to their meetings.

Stephen Pickford points out that the financial sector reform agenda has grown substantially in complexity, particularly in terms of the range of institutions covered, the breadth of instruments subject to regulation, the level of detail involved, and their cross border implications. As to lessons from the experience of the G20 and financial sector reform, Pickford notes that: pressure from leaders does produce responses; most G20 finance ministers and central bank governors fortunately have policy responsibility for the financial sector; it is important to have a technical body to translate political ambitions into concrete actions; and peer review is an important part of the enforcement mechanism.

Richard Gray notes that the progressive implementation of this extensive regulatory reform agenda, which is designed to increase the resilience of the global financial system, has renewed attention on issues such as the extraterritorial impacts of domestic reforms, regulatory inconsistency, and the fragmentation of financial systems, with efforts now being made to ring fence the capital and liquidity of local entities. Gray suggests that these trends can have a detrimental impact on financial market efficiency by creating uncertainty, uneven playing fields and additional compliance costs.

Hugh Jorgensen reviews the IMF’s stocktake of the international community’s progress towards a safer financial system that can better serve the real economy. [2] This is no easy assessment, as the precise attributes of the financial system being pursued were not clearly defined in advance of the reform agenda. Accordingly, the IMF proposes some normative benchmarks for a ‘safer financial system’. Such a system would be less complex, more transparent, less volatile, better capitalised, have fewer systemically risky linkages, have clearer resolution mechanisms, and the same regulatory standards would apply to similar risks.

The IMF’s assessment is that while the thrust of the reform agenda is heading in the right direction, market-based financial intermediation remains largely unchanged, financial systems remain overly complex, concentrated, interlinked and dependent on wholesale and non-bank funding. In short, there is a long way to go — it is a highly complex industry and a great many reforms are being advanced at the same time.

In a similar vein, I note in my paper that a range of concerns have been raised regarding efforts to strengthen the regulation of the financial system. In many cases what seemed bold, simple and obvious in the aftermath of the crisis has turned out to be much harder to implement. There has been criticism that the approach taken is too complex, leading to added uncertainty. I also address the question of whether structural changes in the financial system are not only making the system safer through new standards, but in a way that is promoting better economic outcomes.

Steven Bardy highlights the impact of the changes to the financial regulatory architecture on the role of securities regulators, and International Organization of Securities Commission (IOCSCO) in particular. Some of the issues raised from a regulatory perspective include; the importance of the FSB respecting the roles and responsibilities of standard setting bodies; the need for the FSB to avoid mission creep; the fact that the G20 has acted as an uncritical rubber stamp of the FSB’s work; the necessity of undertaking a cost-benefit analysis before new regulatory initiatives are launched: and the requirement to understand the cumulative impact of all the reforms.

Ross Buckley’s assessment is that the G20 and FSB have done quite well in responding to the financial crisis. But progress has been more problematic in responding to profound changes in the world of finance that commenced in the 1970s, including: the removal of derivatives from the purview of gaming laws; the removal of capital controls that have contributed to the globalisation of financial systems; the rise of algorithmic and high frequency trading; and the change in behaviour of bankers from a world of prudent intermediation to a world of speculating on markets.

Graham Hodges focuses on the challenges facing the Asian financial system, noting that while Asia has been in the economic ascendancy over the past decade, insufficient attention has been paid to the significant underdevelopment of the region’s capital markets. This is a timely reminder of the need to take into account the specific challenges facing financial systems in emerging markets, specifically in the case of Asia, and of the need to ensure that new regulations aimed at enhancing financial stability do not impede the deepening of financial markets. Hodges points out that while Asia is an extraordinarily diverse region with different countries at different stages of development, if the necessary reforms can be implemented, it will become home to a growing number of the world’s financial centres. The implication is that Asia should play a larger role in setting international financial regulations.

The view of the B20

The preliminary report of the B20 (business representatives from G20 economies) working group on financial regulation recommends that there be ‘…an independent assessment of the results of the financial reform — especially the Basel III capital and liquidity requirements and the impact of reforms on other areas such as trade financing, SMEs financing, and infrastructure financing’.[3] It is not specified who should be the ‘independent’ assessor of the impact of these regulations.

Business also emphasises the importance of providing regulatory certainty, avoiding uncoordinated initiatives that may undermine the harmonisation of global minimum regulatory standards, and progress in implementing the Basel III reform timeline.

What should be on the financial regulation agenda in 2014?

A common view is that the focus of the G20 in 2014 should be one of consolidation and implementation. This was articulated by the Governor of the Reserve Bank of Australia, Glenn Stevens, when he recently said ‘absent some major new developments, which brings to light some major reform - need not hitherto visible, to task the regulatory community and the financial industry with further whole-sale changes from here would risk over-load’.[4]

Bardy suggests the focus in 2014 should be on orderly implementation of work to date. But he also goes on to suggest reviewing the cumulative impact of the regulatory reform agenda, particularly in terms of balancing the quest for stability with the economic impact of the new standards, along with reviewing how the work is conducted.

Gray proposes that the G20 needs to refocus its work on coordinating the regulatory reform agenda and to move from monitoring and reporting to taking a more direct role in the implementation process. Towards that end, he proposes that the FSB be given additional resources and an expanded mandate. Gray also calls for a process that requires regulators to consider extraterritorial impacts when developing and implementing regulations. In order to avoid duplication in complying with similar regulations in different jurisdictions, he recommends that ‘substituted compliance’ be introduced.

Hodges also highlights the importance of consistent application of Basel III rules across regional jurisdictions, noting that this will encourage cross-border financing while minimising unnecessary complexity. In terms of promoting financial integration in Asia, he advocates a pan-regional approach that would see national capital market development plans providing for future regional market integration with common regulatory and operating standards.

Buckley suggests the priorities for responding to the profound changes in the global financial system should include further progress in regulating credit rating agencies, in particular the ratings of structured products, along with tighter controls over banker remuneration. He also suggests the G20 should advance the concept of imposing a levy on the assets of financial institutions, limit the activities of deposit-taking banks from engaging in proprietary trading, and introduce a financial transactions tax in order to curtail short-term, speculative transactions.

In my paper, I suggest that what has been missing from the G20’s involvement in financial regulation is consideration of ‘higher-order’ issues. To broaden, intensify and re-energise political involvement in international financial regulation, I have proposed that a Finance Ministers and Central Bank Governors Committee on Financial Regulation be established. It would consist of G20 finance ministers, central bank governors and heads of regulatory agencies along with the non-G20 members of the International Monetary and Financial Committee (MFC)plus Hong Kong. It would meet at the time of the spring and annual IMFC meeting and would replace the G20 finance ministers meeting held at that time. The committee would have a specific charter, which would cover not only oversight of the development and implementation of the new regulatory standards, but also their overall impact on financial stability and economic growth. The secretariat to this committee would be the FSB and IMF.

Conclusion

It is not surprising that financial regulation has featured so prominently on the G20 agenda. The first G20 leaders’ meeting was a response to a devastating financial crisis and the public wanted some assurance that steps were being taken to ensure that a similar crisis would be avoided. And it is appropriate that the G20 continues to focus on financial regulation, because the financial sector has been, and is likely to continue to be, a source of economic crises. With this in mind, a theme the G20 should pursue in 2014 is how it can play a stronger role in overseeing the strengthening of financial regulation. Steven Bardy has summarised the shortcomings of current arrangements when he observes ‘[the G20] has tended to act as an uncritical rubber stamp of the FSB’s work. It should aim to challenge the FSB in the work it does’. Making this happen is the challenge confronting the G20 in 2014.

Hugh Jorgensen[5]

Introduction

It is nearly five years since Lehman Brothers’ filing for chapter 11 bankruptcy brought the global financial system to its knees.[6] Yet it was the corresponding free-fall in the real economy[7] that led legislators in the world’s major financial centres to acknowledge that prudential officials operating within and between their own economies lacked the adequate ‘institutional infrastructure’ to properly supervise the product innovation and globalisation of credit that had driven growth in the global financial industry over the previous two decades.[8] In particular, regulation had not successfully adapted to the boom in more ‘market-based’ activities: fee-based income sources, trading activities, non-deposit liabilities, nonbank financial intermediation and ‘exotic’ securitisations and derivatives.[9] These innovations represented a marked shift away from ‘traditional bank-based intermediation,’ where profits were essentially the differential between interest rates charged on loans over those paid out on savers’ deposits.[10] Accordingly, regulators, supervisors and central bankers, operating at both the multilateral and domestic level, have since been tasked by G20 leaders to devise a host of financial regulatory reforms that:

supplement strong microprudential regulation with a macroprudential overlay to more effectively monitor and address the build-up of risks arising from excess liquidity, leverage, risk-taking and systemic concentrations that have the potential to cause financial instability.[11]

While it is still too early to offer a binary assessment of whether this post-crisis reform agenda has been ‘successful’ or ‘unsuccessful,’ the sheer breadth and depth of financial regulatory reform that has emerged in the past five years does call attention to an important and somewhat overlooked interim question: are we at least making progress towards a safer financial system that can better serve the real economy?

This is a complex question, as it requires an integrated understanding of reforms occurring within major financial centers such as Europe, the US and the UK, how well these reforms correspond to commitments made in transnational regulatory coordination processes like Basel III, and the impact these reforms will likely have upon existing forms of financial intermediation. A preliminary ‘investigation’ in to this infant debate can be found in chapter three of the IMF’s October 2012 Global Financial Stability Report (GFSR), titled The Reform Agenda: An Interim Report on Progress Towards a Safer Financial System.

The IMF’s investigation finds that ‘while the intentions of policymakers are clear and positive, the reforms have yet to effect a safer set of financial structures.’[12] This paper provides: (1) a summary of the goals and expectations for post-crisis reform of the financial sector; (2) a review of the assessment on progress towards a ‘safer financial system’; and (3) a brief discussion of the ‘remaining gaps’ and opportunities for improvement in the reform agenda.

Goals of ‘the reform agenda’: more transparency, less complexity, less leverage

The premise of the GFSR review is that to make an assessment of progress towards a ‘safer financial system,’ it is first necessary to define what such a system might actually look like. The IMF approaches this task by looking for transformations in three structural features of the pre-crisis financial landscape that exacerbated or facilitated the 2008 banking meltdown: principally, the move to (i) more deregulated market-based intermediation, (ii) highly concentrated financial systems and (iii) financial globalisation. Accordingly, a hypothetically ‘safer financial system’ - relative to the pre-crisis system — would exhibit the following ‘normative benchmarks,’ against which progress can be measured:

• Better information: a financial system that is less complex and more transparent than that of the pre-crisis period, where investors and regulators better understand the risk profile of investments and can more accurately price ‘all risks, including systemic ones;’
• Less volatility: a less leveraged system with lower levels of maturity mismatch and pro-cyclical liquidity risks;
• Better capitalised: financial institutions that operate with ‘higher and better quality capital and liquidity buffers’ that can more effectively withstand periods of severe distress and thereby avoid insolvency;
• Less systemic risk: a financial sector that involves less systemically risky linkage between the banking sector, non-banking sector and foreign banking sector such that contagion risk is limited;
• Better resolution of failed banks: clearer resolution mechanisms for systemically important financial institutions that impose a minimal cost upon taxpayers; and,
• More coordinated regulation: better alignment of prudential standards for similar risks, so as to de-incentivise regulatory arbitrage.

Importantly, the proposed normative framework does not simply advocate for the abandonment of all recent innovation in the global financial sector. Rather, the goal is to maintain the ‘efficiency benefits’ of positive innovations, like financial globalisation, while bringing greater clarity to the risk-profit trade-off that is made when choosing between traditional and non-traditional models of intermediation. For example, ‘well-conceived’ products that disseminate the concentration of risk to those most able to bear it — like corporate bonds and equities — can promote credit and economic growth, while more opaque products, such as the subprime derivatives behind the recent crisis, can result in extremely costly spillovers. Accordingly, in addition to desiring fewer ‘taxpayer-paid bailouts’ and ‘large disruptions to economic activity,’ the GFSR assents to post-crisis reforms that incentivise financial institutions to more effectively:

…internalise the risks and explicit or implicit costs of their business activities, mainly through the imposition of additional costs on activities that, in the crisis, were shown to be riskier than originally envisaged or had broader systemic effects.[13]

A brief and early look at reform expectations

The implementation of the post-crisis global regulatory reform agenda is still in very ‘early days.’[14] Indeed, by January 2013, regulations relating to the enhanced capital and liquidity requirements of Basel III had only commenced ‘rollout’ in eleven of the twenty-seven Basel committee member jurisdictions,[15] with several other key jurisdictions, including the United States and members of the European Union, yet to move beyond the drafting stage.[16] As discussed below, the targeted activities broadly involve banking, non-banking finance and OTC derivative trades. The delay in implementation relates to differing perspectives and expectations over the key policy objectives that have made up the ‘ambitious and global’ reform agenda to date, as well as their potential impact on the broader financial landscape.[17]

Banking & non-banking intermediation

Increasing capital charges on higher risk-weighted assets (RWAs) and revising minimum liquidity coverage ratios (LCRs) will likely incentivise banks to optimise the composition of their balance sheets by expanding into business lines that demand lower capital charges and less costly liquidity standards. Tighter definitions of capital, the introduction of leverage ratios, and additional surcharges on globally systemically important banks (G-SIBs), should also encourage banks to ‘deemphasise’ activities that involve higher RWAs.

Yet if these reforms are effective, they will ultimately lead to lower short-term returns on equity. Depending on the demands of investors in financial institutions, this may unintentionally cause a shift in banking business models towards even more market-based intermediation, as activities that demand more capital will become less attractive than net interest margin focused products (NIM — ratio of interest earned minus interest paid over total interest-earning assets).[18] Even where banks do divest their non-traditional business-lines due to increased capital costs, the potential for exacerbating market concentration and the risks posed by ‘too-big-too-fail’ banks might still increase, as larger competitor banks with scalable business models may simply capture any abandoned market share.[19]

Furthermore, non-banks that are not subject to the same standard of capital or liquidity reserve requirements might become even more attractive instruments for intermediation, as their relative competitive cost position against banks would likely improve, essentially luring even more intermediation into the opaque world of shadow banking. Although shadow banking can broaden access to finance and improve market depth, the limited amount of satisfactory data on nonbanking activities does suggest greater regulatory attention should be devoted to uncovering potential systemic risks within the sector.[20]

OTC derivatives

The most ‘far-reaching’ component of the plan to reform OTC derivatives is to shift non-cleared OTC transactions onto central counterparties (CCPs). A well-coordinated transition to the use of CCPs should lead to more effective risk dispersion and resiliency within the financial system. However, an insufficiently detailed or supervised transition may result in insufficient competition between CCPs, which could result in even more efficiency losses and market opaqueness than before the crisis. For example, while the objective is to bring greater transparency to the OTC market, the concentration of OTC derivatives on the balance sheets of newly created CCPs may actually engender a whole new class of systemically important financial institutions that become ‘too-big-to-fail.’

If the above reforms are fully implemented as intended, it is probable that they will lead to more ‘stable, traditional banking’. Yet there are evidently potential pitfalls if the reform agenda is weakened or only partially fulfilled — not least due to the natural incentive for highly innovative and well-resourced financial institutions to circumvent new regulations or exploit unforeseen loopholes.

The next section looks for early evidence that progress is being made overall.

An early assessment of whether post-crisis reforms are resulting in a safer financial system:

Although the GSFR finds that ‘the thrust’ of the post-crisis reform agenda is ‘pushing in the right direction’ and that some ‘improvements along some dimensions [in] some economies’ are discernible, its overall conclusion is that market-based financial intermediation remains largely unchanged and that financial systems are still overly complex, concentrated, interlinked and dependent on wholesale and non-bank funding. Essentially, while the report’s authors stress that their findings are tentative, the indicators used in their analysis do suggest that post-crisis reforms are yet to make financial systems ‘safer than before the crisis’.[21]

‘Market-based intermediation: dented but not reversed’[22]

While some market-based intermediation activities have experienced a post-crisis decline, the general level of non-traditional banking activity in advanced economies remains relatively unaffected.[23] This is concerning, as previous IMF studies show that banking systems which exhibited ‘excessive’ reliance on ‘non-traditional’ sources of income were among the hardest hit in the financial crisis.[24]

The non-bank sector’s role in intermediation has also fallen only slightly in advanced economies, with its share of the total financial sector’s loan and bond holdings remaining largely stable — although this figure is likely propped up by the increased issuance of corporate bonds after the fall in demand for securitised products such as mortgage backed securities (MBS), collateralised debt obligations (CDOs) and over the counter (OTC) derivatives.

The level of non-traditional banking in emerging economies remains at a fairly low and static level, where it has not historically been a significant contributor to the revenue of financial institutions.

Concentration: ‘financial systems are still concentrated, with strong domestic interbank linkages.’[25]

Concentration in advanced economy banking sectors has actually increased in the wake of the crisis,[26] largely due to mergers of distressed banks with healthier ones, or the amalgamation and nationalisation of ailing banks. Even where less distressed institutions were able to successfully sell off business lines and riskier components of their balance sheet in order to meet minimum capital requirements, these assets were generally acquired by larger and healthier institutions and thereby effectively exacerbated, rather than ameliorated, the risk and moral hazard represented by ‘too big to fail’ (TBTF). Nevertheless, despite an increase in nominal terms, there has at least been a proportional decline in the size of the global financial sector relative to GDP.[27]

There has also been little change in the general level of ‘interconnectedness’ among financial institutions within advanced economies - measured by the ratio of interbank assets, liabilities and wholesale funding as a proportion of the total respective figures for each bank. However it is worth noting that this figure also captures wholesale funding from central banks, which have become key post-crisis providers of liquidity, and is therefore probably inflated.[28]

Relatedly, the ongoing influence of crisis intervention policies from governments and central banks, which initially prevented a total financial collapse, may be slowing efforts to create a safer financial system. Indeed, while the expansion of central bank balance sheets in Japan and the euro area may be a necessary response to sluggish credit markets, crisis induced monetary policies unaccompanied by structural reform of the financial system might in fact be ‘inhibiting adjustments in the structure of banking systems.’ For example, the IMF estimates that because of implicit government guarantees, bigger banks are able to borrow funds at a discount of 0.8 percentages points over their smaller counterparts - for the five largest banks in the United States, this equates to an annual subsidy from the government of around $64 billion.[29] Ongoing cheap interest rates, courtesy of central bank policy, might even increase the attractiveness of investing in higher RWAs where higher yields are available than in traditional banking.

Financial globalisation: not severely affected as yet

On a slightly more positive note, the IMF finds that long-term trends in financial globalisation have ‘not been significantly affected,’[30] ‘despite reversals from some crisis-hit economies.’ The measure for financial globalisation is gross foreign asset holdings by banks as a percentage of GDP. Generally the levels have remained steady at around eighty per cent in selected advanced economies, and have increased from about sixty to seventy per cent in Asian economies (other regions remain static). However while there is presently no significant evidence of a move towards de-globalisation, it could still occur if the reform agenda fails to deliver a ‘level playing field and good cross-border resolution framework.’[31] Furthermore, without significant structural reform, those institutions with higher exposure to foreign assets or streams of financing will remain more susceptible to global contagion than their more ‘domesticated’ counterparts.

Data analysis

Drawing on available data from forty-five countries,[32] the IMF have also devised several financial indices to test for a relationship between progress toward the normative benchmarks listed earlier and each country’s level of implementation of standards approved by the Basel Committee on Banking Supervision (BCBS).[33] The econometric analysis essentially finds that there is a tentative but statistically significant relationship between implementation of previous rounds of BCBS regulatory measures and the likelihood that banking systems have taken steps to alter their liability structures and re-engage in securitisation activity (albeit in a more tightly controlled fashion relative to pre-2008).

Of concern, the econometric analysis also finds a negative relationship between the BCBS standards and rates of financial globalisation, particularly in banks providing intermediation services in foreign markets;[34] whether this is only a result of the particular period under assessment or the beginning of a long-term trend deserves more research, as it may suggest that BCBS rules need to be tweaked in order to maximise the benefits of cross-border risk sharing.

Yet the broader point here is that the interpretation and implementation of BCBS standards remains misaligned among systemically important economies, which is in itself a major pitfall for the objective of minimising regulatory arbitrage.[35]

 Implications of GFSR findings: policymakers need to speak more about reform ‘tweaking’

In answering the question ‘are [post-crisis] reforms moving the structures toward a safer financial system,’ Laura Kodres, the IMF’s head for global financial stability, pithily summarises with the comment ‘somewhat, but not enough.’[36] This is evidently an area where sound analysis will require ongoing monitoring, and the GFSR provides a useful blueprint for the complex task of taking a qualitative and quantitative ‘stocktake’ of post-crisis global financial reform on a regular basis. It also contains lessons for policymakers and officials within G20 economies on which areas of reform are most in need of attention, enhancement or rethinking. Several such areas that warrant deeper consideration from policymakers relate to:

1. ‘Too important to ail’: Policymakers should commence ‘a global level discussion on the pros and cons of direct activity restrictions’ because national initiatives that force banks to divest or ‘ringfence’ certain business lines, like the Liikanen, Vickers and Volcker proposals, will have an impact beyond domestic borders. Left uncoordinated, global standards may become even more uneven; indeed, early studies by the Bank for International Settlements have identified ‘considerable variation’ in the risk weighting of assets across banks and jurisdictions.[37] 
2. More effective ‘recovery and resolution planning for large institutions’ than is currently taking place, particularly for G-SIBS with significant cross-jurisdictional operations.
3. ‘Enhanced monitoring of systemic risks posed by nonbanks’ — it is clear that by raising the cost of consuming higher RWAs for banks, that non-banks will become relatively more cost-competitive providers of intermediation. If policymakers wish to prevent even more financial intermediation from leaking to the non-bank sector, then a common (or at least better aligned) set of prudential standards is required for both banks and nonbanks.
4. ‘Further thought on how to encourage the development of simpler products’: policymakers should do more to encourage better quality information that reveals interconnections, buildups and potential spillovers of the risks inherent in financial products.
5. ‘More consideration of risks in moving OTC derivatives to CCPs’: as discussed earlier, insufficient attention has been paid to the potential risks inherent in creating a new class of essential financial intermediaries like CCPs that, left unchecked, could become TBTF in their own right.

Evidently, moving towards a less volatile global financial system with more effective prudential supervision will require a truly global compact. Yet the ongoing complexity, lack of transparency and highly leveraged nature of global finance means that a great deal more of political and social impetus is required if the normative benchmarks listed at the beginning of this paper are to be credibly pursued. Unfortunately, it is by no means assured that the right incentives are presently in place to meet the benchmarks, or that supervisors have been imbued with sufficient authority to enforce them. Indeed, the GFSR chapter closes with the somber warning that without sufficient political leadership or effective support from the relevant global economic governance institutions, the global financial reform agenda may ‘wither and die’. The challenge for the G20 is to galvanise its own members into ensuring that it does not.

Stephen Pickford[38]

Introduction

This paper focuses on the following points:

• Financial sector reforms have been an important feature of the G20’s agenda since 2008, when G20 Leaders first met in Washington.
• Financial sector issues have been one of the more successful examples of the G20 as a mechanism for international policy coordination. The Financial Stability Forum (FSB) was strengthened to effectively become an instrument of the G20 to formulate detailed actions to put political agreements into practice, and to oversee implementation.
• Over successive summits the agenda of financial sector reform has grown substantially in complexity; the G20 has made major strides forward in these areas over the last five years, and its agenda has evolved to reflect changes in the financial landscape. But while the FSB has helped drive forward the political priorities of greater coordination on financial regulation, detailed implementation of regulations at the national level is still lagging behind.
• The relative success of the G20’s efforts in financial sector reform are due to political leadership through the summit process, policy ownership by finance ministers and central bank governors, a permanent technical body to oversee and implement agreements, peer review processes to encourage national implementation, and an overriding rationale for international cooperation. This may have lessons for other areas of the G20’s work.

Reform of financial regulation has been a priority issue for the G20 since its rebirth as a leaders’ process in 2008.

Financial sector failures, both of private financial institutions and by supervisors and regulators, were at the heart of the global crisis of the late 2000s. As a result, financial sector strengthening formed a key part of G20 discussions at the Washington summit in November 2008. A comprehensive action plan was formulated and a number of international institutions were tasked with taking forward different aspects of the plan.

In particular the Financial Stability Forum (FSF), which had been set up at the same time as the finance ministers and central bank governors G20 in 1999, brought together finance ministries, central banks and regulators of the major financial centres. Following the Washington summit it was given a broad oversight role for financial sector reform, its membership was expanded to include all the G20 countries, it received more resources and responsibilities, and it was renamed the FSB.

At that time the G20 stressed: ‘regulation is first and foremost the responsibility of national regulators.’[39] But the rationale behind coordinated international action was clear — ‘our financial markets are global in scope, therefore, intensified international cooperation among regulators and strengthening of international standards, where necessary, and their consistent implementation is necessary to protect against adverse cross-border, regional and global developments affecting international financial stability’ — even though achieving that level of coordination was not easy.

The crisis showed that if the state provides guarantees, either implicitly or explicitly, to important institutions, sectors or instruments of the financial system (so that they are too important to fail), some private institutions will be tempted to take too many risks. And unless failing institutions can be ring-fenced, one failure can bring down the entire system, with catastrophic consequences both within and across national borders. So the issue of financial stability became a key public policy issue for G20 countries, individually and collectively.

Financial sector reforms

In successive summits since then, the G20 program of financial sector reform has expanded its scope and drilled down into greater detail, including:

• Strengthening of the Financial Stability Board;
• changing the approach to risk management in private financial institutions, including through controls on compensation systems;
• Instituting a new bank capital and liquidity framework to constrain leverage and maturity mismatches, capital buffers and leverage ratios;
• Addressing the ‘too-big-to-fail’ issue through a resolution framework and more intensive supervisory oversight for systemically important financial institutions (SIFIs), as well as building a robust core financial market infrastructure; and
• Instituting mandatory international recovery and resolution planning and risk assessment by international supervisory colleges, in particular for global systemically important financial institutions (G-SIFIs).

In addition, at the Seoul summit the G20 mandated a further program of work[40] covering:

• International peer review of national supervisors;
• Strengthening regulation and supervision of hedge funds, over-the-counter derivatives, and credit rating agencies;
• Creating a single set of global accounting standards;
• Further work on macroprudential policy frameworks; and
• Strengthening regulation and supervision of the shadow banking system and derivatives markets.

At Cannes the G20 committed to full implementation of this reform agenda and the creation of a global legal entity identifier (LEI[41]) to identify parties to financial transactions. Los Cabos repeated these commitments and pledged to make national resolution regimes consistent with the ‘Key Attributes’[42] developed by the FSB.

Over successive summits this agenda of reform has grown substantially in complexity, in five dimensions:

• The range of institutions covered by the supervisory net has risen dramatically, from banks and insurance companies initially, to bring into the net hedge funds, other forms of ‘shadow banking’, and the financial infrastructure institutions (clearing and settlement systems, and credit rating agencies);
• The coverage of instruments under detailed regulation has increased, notably for asset-backed securities, and OTC derivatives;
• The level of detail on capital, liquidity, leverage, accounting standards, and conduct of business issues has also expanded dramatically. For example, Basel I ran to 30 pages, Basel II to 347 pages, and Basel III to 616 pages;
• The processes around supervision have also been strengthened, for example the setting up of supervisory colleges, and processes for bank resolution, especially for SIFIs; and
• Measures have been introduced aimed at regulating the behaviour of financial institutions, e.g. guidelines on compensation, and corporate governance.

While these measures have primarily been taken forward internationally through the FSB and the standard-setting bodies (including the Basel Committee, the IASB and IOSCO)[43], much of this agenda has to be implemented by the relevant national regulators and supervisors.

The state of progress with the reforms

Given the starting level of international cooperation on regulation and supervision in 2008, the G20 has made major strides forward in these areas over the last five years. The process of international coordination and convergence of standards for financial regulation and supervision has gathered momentum, driven by the institutional structure of the FSB. And over time the agenda has evolved to reflect changes in the financial landscape.

But while the FSB has helped drive forward the political priorities of coordination on financial regulation, detailed implementation of regulations at the national level is still lagging behind. The assessment of the G20 Research Group[44] is that implementation by some countries (especially the United States, Canada and European countries) has been good, but that overall this is one of the weaker areas of G20 implementation (with an average score of 0.23). And in a recent speech[45] the IMF’s First Deputy Managing Director, David Lipton, also concluded that the global regulatory reform process had made significant progress, but that countries needed to speed up implementation of the new rules, including the Basel III capital rules, the liquidity coverage ratio for banks, and recovery and resolution plans for G-SIFIs.

Nevertheless, compared with the speed of progress on regulatory reform before the crisis, G20 pressure has ensured much greater and faster progress than would have been likely with the pre-2008 structures for international cooperation. Of course, given the causes of the crisis, lack of action in this area was not an option. And the strengthening of the financial system cannot guarantee that there will not be failures in the future. But overall the coordinated response to the shortcomings of the global integrated financial system has been much more effective than prior to the crisis.

Conclusion and lessons

There are a number of lessons from this experience:

• Pressure from leaders does produce official responses: G20 summits have proved a very effective way of reaching agreement between countries and across different parts of national administrations. Finance ministries, central banks and regulators within a single country can have divergent views or agendas. In those circumstances only leaders can force the institutions to bury their differences. Even in very technical areas such as financial regulation (where leaders and their advisors are unlikely to have complete mastery of the details) they can be effective;
• Finance ministers’ and central bank governors’ policy responsibilities in this area allow effective responses at the national level: in most countries finance ministers have policy responsibility for the framework of financial supervision and regulation, and central banks often have executive responsibility for regulating and supervising major parts of the financial sector. And central banks have typically been the main conduit for international coordination in this area through the Basel Committee. So the G20 meetings of finance ministers and central bank governors are important venues for preparing the leaders’ discussions at summits, and for ensuring implementation within their countries of what has been agreed;
• An effective technical body is needed to translate political ambitions into concrete actions, and to enforce implementation: in this area the FSB has played a very important role in translating political will into concrete agreements on new regulatory measures. The FSB’s role as a coordinating mechanism for standard-setting bodies in the financial area has allowed it provide a degree of consistency across different parts of the financial sector. But in order to increase the capacity and effectiveness of the FSB it was necessary to strengthen its administration and to expand its membership so that it was seen as a legitimate body to coordinate internationally. In particular, the decision in 2009 to expand its membership to include all G20 countries was essential in legitimising its role as a delivery mechanism for the G20; and
• Peer review is an important part of the enforcement mechanism: since regulation and supervision remains essentially a national competence, a key challenge in this area is to ensure that agreements at the international level are translated across to national legislation and (as importantly) are put into practice by supervisors equitably across national boundaries. In Europe the Commission and ECB can play this role; but more broadly this is a challenge. The FSB has adopted widely the practice of peer review so that national regulators and supervisors are assessed by their counterparts from other countries to ensure a level playing-field, but despite this, to date the FSB has been more successful at getting regulators to agree new regulatory measures than at ensuring that they are implemented at the national level.

These lessons could well have wider applicability in other areas of the G20’s work. They are already standard practice in macroeconomic coordination, in particular through the MAP (though with less impressive results to date).

Richard Gray[46]

Synopsis

This paper examines the role of the G20 in establishing a comprehensive regulatory reform program for the international financial system and suggests that it may be timely for the G20 to further increase its active coordination of the program in order to maximise the effectiveness and international cohesiveness of the reforms with consequent enhancement of global system stability and efficiency.

Introduction

There has been a profound transformation of the financial regulatory landscape over the past five years. The turmoil and subsequent economic impact of the global financial crisis (GFC) exposed the need for reform of the financial sector. Specifically, the global financial system needed to be made more resilient to shocks, transparency of activities needed to be increased, while risks needed to be more appropriately managed and regulated. 

The first G20 leaders’ summit in November 2008, soon after the peak of the GFC, set the agenda for reform of the global financial system. At that first meeting, G20 leaders set out common principles for financial market reform, including sound regulation, strengthened transparency and greater integrity. In particular, leaders specified that international cooperation and coordination of regulatory efforts was important so as to ensure consistent formulation and implementation of reforms.

The G20 London summit in April 2009 saw the re-establishment of the Financial Stability Forum as the Financial Stability Board (FSB), with a broadened mandate which specified the coordination of those bodies responsible for international financial stability. The Pittsburgh summit of September 2009 specified ‘target reform areas’ including enhanced capital requirements, strengthened liquidity requirements, improving over the counter derivatives markets and addressing cross-border resolution and systemically important financial institutions. These determinations laid the broad framework for the financial regulatory reform agenda.

Trends

The comprehensive regulatory reform program has been designed to significantly increase the resilience of the global financial system, enhance the preparedness of institutions and markets in the face of potential shocks and provide protection to consumers and taxpayers. Regulators around the world have worked intensively to implement what represents unprecedented reform of the international financial system. However, as the extensive range of reforms has been progressively implemented, we have seen the emergence of several issues across the international regulatory landscape that are worthy of renewed attention.

• Extraterritoriality: Each member jurisdiction is seeking to develop and implement domestic regulations that satisfy their commitments in the G20 reform agenda. However a number of these regulations have extraterritorial impacts. For example, some of the regulations set out in the Dodd-Frank Act of the United States, such as the Volcker Rule or the OTC derivatives/swaps requirements, potentially have far reaching effects beyond the United States due to certain broad definitions or specifications incorporated in the legislation. In some cases the extraterritorial effects of legislation do not appear to be intended and, if left unchanged, will lead to particularly difficult paths to compliance for those affected.
• Inconsistency: Different jurisdictions, in seeking to implement global regulatory reforms, are often adjusting aspects of the international regulations including the content, the timing or the implementation approach. Such inconsistency may cause issues for those subject to the regulations in more than one jurisdiction and may impact the efficient delivery of financial services and the effective functioning of international capital markets.
• Fragmentation: Due to inconsistent local implementation of global reforms, several instances of potential regulatory fragmentation have emerged. In a speech in February 2013, the FSB Chairman Mark Carney highlighted the risks to market efficiency and to global system resilience posed by this trend: ‘Measures to ring fence the capital and liquidity of local entities are being proposed. Left unchecked, these trends could substantially decrease the efficiency of the global financial system. In addition, a more Balkanised system that concentrates risk within national borders would reduce systemic resilience globally…… A global system that is nationally fragmented will lead to less efficient intermediation of savings and a deep misallocation of capital. It could reverse the process of global economic integration that has supported growth and widespread poverty reduction over the last two decades’.[47]

These trends have led a number of finance officials in different jurisdictions to raise certain issues directly with their counterparts. For example, in April 2013 finance ministers and officials from nine jurisdictions and the EU sent a letter to US Treasury Secretary Lew to ‘express our concern at the lack of progress in developing workable cross-border rules as part of the reforms of the OTC derivatives market.’[48] The letter talks of evidence of regulatory fragmentation due to a lack of regulatory coordination and, in order to avoid regulatory conflicts and minimise overlaps, the officials propose measures aimed at agreeing to more appropriate outcomes in relation to implementation timetables, registration requirements and ‘substituted compliance.’[49]

Also in April 2013, European Commissioner Barnier wrote to US Federal Reserve Chairman Bernanke regarding certain aspects of proposed prudential regulation of the operations of foreign banking organisations in the United States. Barnier talks of the potential fragmentation of global banking markets and regulatory frameworks as a result of the proposed rules and also cites their potential for creating an uneven playing field. Barnier  also raises the possibility that the proposed rules ‘could spark a protectionist reaction from other jurisdictions, which could ultimately have a substantial negative impact on the global economic recovery.’[50] Any such response would of course directly conflict with one of the objectives set down by the G20 at their inaugural leaders’ summit, which called on leaders to avoid protectionist actions in implementing the post GFC reform program.

It should be acknowledged that some of these developments reflect the fact that an unprecedented program of international financial reform is being undertaken. Further, because many of the reforms represent new territory for regulation, the potential impacts have only emerged as the detailed rules have been developed or new requirements have been proposed and progressed.

In addition, some of the issues that have emerged simply reflect the differing states of development experienced by markets in different jurisdictions, distinctive market characteristics or the varying stages of development or implementation of regulations.

Another aspect which has contributed in some instances to these trends has been a disconnect between the priorities of some lawmakers, particularly in response to a perceived mood among the community for action, and the likely approach to reform proposed by regulators who may seek more consistent and measured regulatory responses and more appropriate and reasonable timetables.

Potential impacts

The emergence of these trends creates the potential for several unintended impacts. The overriding impact is one of uncertainty, and uncertainty can be detrimental to growth because of the effect it has on confidence. It is more difficult for banks to invest in, and grow, business areas confidently if the path to regulatory compliance for those businesses is uncertain or if they face the prospect of multiple compliance requirements across different jurisdictions for essentially the same types of activities. Product development and customer engagement is similarly affected in a less certain and fragmented regulatory environment.

Another potential negative impact is the creation of an uneven playing field — where participants from one jurisdiction may end up having some advantage due to inconsistent implementation of regulations. This may lead to reduced competition as institutions withdraw from certain products, or even completely from certain markets, due to regulatory disadvantage.

The cost of compliance is a further issue. Banks are willing to support compliance frameworks that make the financial system more resilient. However where there is an unclear path to compliance (due to looming deadlines but incomplete regulations) or multiple compliance requirements due to unforeseen extraterritorial effects, the compliance investment can be inefficient and inappropriately directed creating unnecessary cost for all participants in the system.

A significant issue for international markets is the detrimental impact on financial market efficiency caused by the ‘Balkanisation’ of cross-border banks’ operations in different jurisdictions, as mentioned by Mark Carney. This could lead to trapped capital and liquidity in each of these jurisdictions leading to significantly reduced efficiency of flows in the international capital markets.

These potential detrimental impacts are emerging at a critical time in the economic cycle given the fragile state of the global economic recovery.

Some suggestions

The international regulatory reform program is at a crucial stage. There have been some encouraging signs of regulators seeking to address these issues or examples of increased co-operation between regulators — in late 2011 the FSB set up a Coordination Framework for Implementation Monitoring to intensify its monitoring of implementation of the reform program. Also in late 2011 the principals of regulatory authorities charged with regulating OTC derivatives markets in eight countries, as well as the EU and two Canadian provinces, formed the OTC Derivatives Regulators Group to discuss reform of the derivatives markets, including the objectives of increasing regulatory certainty, minimising inconsistent regulation and avoiding duplicative requirements.

However, as discussed, there continue to be examples of uncertainty, regulatory inconsistency and potential fragmentation.

It should be acknowledged that, given the nature and extent of the international regulatory reform agenda, it is inevitable that some unintended consequences will emerge. Further, it is extremely challenging to develop such a broad range of regulatory measures in a way that achieves the desired objectives in a consistent and effective manner given the different characteristics and stages of development of the many jurisdictions for which the regulations are being designed.

However, it is timely that the G20 and its agencies consider the regulatory reform landscape and evaluate measures that could further enhance the extensive progress achieved to date. The following suggestions are proposed to contribute to this debate:

• The G20 should increase its efforts to actively coordinate the international regulatory reform agenda. Over recent years, despite comments at the early leaders’ summits regarding coordination, the focus has largely been on monitoring and reporting on the progress of implementation of the regulatory reforms. More direct active involvement is justified given the issues that are emerging in the implementation of the reforms.
• In particular, the G20 could reinforce and strengthen the mandate of the FSB as its official agency in the active co-ordination of the regulatory reform program. The international financial community welcomed the re-establishment of the FSB in 2009 with a broadened mandate. It was also a positive development in early 2013 when the FSB was formally constituted as a legal entity. It would be timely for the FSB to take a more proactive role in seeking to coordinate the development and implementation of the G20 financial reform agenda. Under an expanded and strengthened co-ordination mandate, it would also be crucial that the FSB is sufficiently resourced so that it can effectively carry out this critical function.
• The G20 could specifically direct the FSB to address the aspect of extraterritoriality in the formulation, development and implementation of regulations. The FSB could provide guidelines that formally require regulators to consider potential extraterritorial impacts when developing and implementing regulations for their jurisdictions. A review process could be implemented which allowed for potential instances of extraterritoriality to be considered in a FSB sponsored forum.
• It is inefficient to require duplicated compliance with similar regulations in different jurisdictions. The reform of OTC derivatives activities is particularly relevant to this issue. Different jurisdictions may be firmly committed to the G20 objectives pertaining to central clearing, trade reporting and exchange trading of derivative transactions. However, due to the different nature and characteristics of markets, the legislative and regulatory frameworks in these jurisdictions will rarely be identical. The process of substituted compliance provides an apposite solution to this issue. However in order for the substituted compliance process to be reasonable and effective, the comparability assessment should be outcomes based, rather than a line-by-line comparison of regulations, and be sufficiently flexible to take into account differences in markets, different stages of development and local conditions. The process should be collaborative to provide for a progressive assessment and determination. It should also provide sufficient information as to identified gaps, how they can be reasonably filled and time to do so. This issue of substituted compliance is becoming an increasingly important feature of the international regulatory landscape and the FSB could develop a process framework that could form a roadmap for regulators to follow in conducting their comparability assessments and substituted compliance determinations.

Timetables

One aspect of the regulatory agenda that is contributing to many of these issues is that in some cases the timetables for development and implementation of regulations are proving to be impractical. Many of the original deadlines for reform of the different areas were set during 2009 in the immediate post GFC turmoil, no doubt influenced by the prevailing mood of a need for significant change and rapid action. An example is the ‘end 2012’ deadline for implementation of the OTC derivative reforms. The FSB’s Fifth Progress Report on implementation of the OTC Derivatives Market reforms published in April 2013 acknowledged that not one member jurisdiction had fully implemented the requirements by the ‘end 2012’ deadline originally set by the G20. However the framework objectives were very high level, and the process of development of legislation and regulations to achieve those high level objectives have no doubt brought into focus the challenges many jurisdictions faced and the ambitious nature of the original deadline.

While continued appropriate reform is accepted as a must by market participants, it is more important in the long run to ensure that the regulatory frameworks which are developed and implemented are the optimal reform measures, not simply those which can be most expediently implemented. Currently the global system appears to have the benefit of some time to achieve such an outcome.

From the perspective of pure loss absorbency capacity, the global banking sector is materially more resilient than in the period leading up to the GFC. Average capital levels have increased significantly over the past five years and, as more countries implement the Basel III capital reforms, along with the increased loss absorbency requirements under the SIFI framework, this trend can be expected to continue.

Further the capital requirements for defined banking activities, along with progressive reforms in the areas of liquidity and OTC derivatives, are influencing the nature and approach of banking activities, leading to improved risk management and further increasing transparency and system stability. In addition, the significantly increased focus on supervision is further strengthening confidence in the resilience of the global financial system.

These positive trends, in concert with a subdued global economic environment, provide a backdrop for the G20 and its agencies to re-evaluate existing proposed timelines and to inform appropriate timetables for proposed new reforms.

Conclusion

The G20 has initiated a program of reform that is dramatically reshaping the global financial landscape. Five years into this reform program it is timely for the G20, and its main regulatory agency the FSB, to re-assert and strengthen their co-ordination role. Although the challenging nature of achieving a consistent but appropriately flexible international regulatory framework is recognised, through active coordination of the reform program, the FSB, and through it the G20, are both well placed to ensure that the worthwhile financial reform objectives of the G20 are most appropriately realised.

Ross P. Buckley[68]

One of the most important decisions this century was when the G7, realising that it had neither the right nations at the table, nor the moral authority, to craft a credible response to the 2008 Global Financial Crisis (GFC), passed the baton of economic leadership to the G20.

As a regulatory response to the GFC, the G20 has done quite well. As a response to how profoundly the world of finance has changed in the past 40 years, the G20 reforms are more problematic. The avoidance of future major crises is likely to require an adequate response to the profound changes in finance since 1970, not merely a response to the specific factors that gave us the GFC.

The main reforms mandated by the G20 include:

• Strengthening capital adequacy rules: Basel III[69]
• Addressing ‘too big to fail’ by regulating systemically important financial institutions[70]
• Regulating the shadow banking system[71]
• Reforming over-the-counter derivatives principally by bringing them onto exchanges[72]
• Strengthening and converging accounting standards[73]
• Building a common legal entity identifier[74]
• Reducing reliance on credit ratings and improving oversight of credit rating agencies[75]
• Enhancing compensation practices[76]

All of these reforms are worthwhile. All matter. Many have lengthy implementation timeframes and progress has been slow, in part because implementation is done by national authorities. However, few of these changes respond sufficiently to the profound changes in the system of the past 40 years and I believe we won’t have a stable system until we adequately address these changes.

The profound changes in global finance since 1970

All of the changes to global finance since 1970 would fill a multi-volume treatise. This paper focuses on (i) the legalisation of financial gambling, (ii) the globalisation of the system, (iii) the rise in algorithmic and high frequency trading, and (iv) the fundamental changes in banks and bankers.

The legalisation of financial gambling

The Gaming Act 1845 (8 & 9 Vict.c.109) in the United Kingdom made gaming houses illegal and gaming contracts unenforceable. Australia, the United States and Hong Kong had broadly similar legislation. For over a century, courts held that derivatives contracts (as they came later to be known) entered into by at least one party for hedging purposes were valid under these enactments, but derivatives entered to place a bet on the price of something were unenforceable.

From the 1980s onwards, legislatures began to exempt derivatives from the application of these laws.[77] In the United States, the Financial Crisis Inquiry Commission in its final report concluded that the enactment of the Commodity Futures Modernisation Act of 2000 ‘to ban the regulation by both the federal and state governments of over-the-counter derivatives was a key turning point in the march toward the financial crisis’.[78] A wide variety of parties had used derivatives to hedge or speculate, but ‘without any oversight, OTC derivatives rapidly spiralled out of control and out of sight’. As Lynn Stout wrote, the enactment of the CFMA was a ‘sudden and wholesale removal of centuries-old legal restraints on speculative trading in over-the-counter (OTC) derivatives’,[79] that played a large role in the 2008 crisis.

The removal of derivatives from the purview of gaming laws was primarily because sophisticated financial market participants were thought to be able to protect their own interests — an assumption falsified by the GFC.

The globalisation of the international financial system

In 1970, capital controls blocked most capital flows between nations. Over the next two decades these controls were progressively dismantled, such that capital now moves freely between most countries. This liberalisation, coupled with the rise of computers and telecommunications, means that capital today is among our most globalised markets. Without these profound changes, the US sub-prime crisis would have remained domestic. Globalised markets have allowed pension funds in Norway and local governments in Australia to lose hundreds of millions of dollars on repackaged US home loans.

Keynes and White crafted a system in 1944 to promote international trade and keep finance national. If designing a globalised financial system, they would have created a global financial regulator, a lender of last resort, and a sovereign bankruptcy scheme — for no national financial system works without these institutions.[80] The current system of financial regulation involving the Basel Committee, BIS, FSB, and other institutions, is a soft-law response to the absence of a global central bank and financial regulator.[81]

The rise in algorithmic and high frequency trading

Algorithmic[82] or computer-driven trading accounts for about 70 per cent of US equity trading and 30 to 40 per cent of European and Japanese equity trading.[83] Algorithms also drive much of high frequency trading (HFT). Research suggests HFT tends to make exchange rates and stock and commodity prices diverge from those reflecting economic fundamentals, because short-term price runs fuelled by algorithmic trading programs accumulate to baseless trends and price distortions. The resulting over-shooting of prices favours speculators over longer-term investors and thereby feeds into ever-higher levels of trading.[84]

The change in banks and bankers

If a lawyer from 1970 were brought forward in time, much would be familiar. The manner of lawyers, the way they carry themselves, the way they are trained, the way they look backwards to find authority, has all changed very little.

Yet if a banker from 1970 were put in a modern investment bank, or in the investment banking arm of a commercial bank, much would be different. The manner of bankers, the way they carry themselves, the way they are trained, and the way they see the world, has all changed profoundly. You needed maths to run a bank in 1970, but it was primary school math. Today bankers are trained in highly mathematical finance and economics, or in maths and physics.

Bankers in 1970 were as prudent, cautious and dull as lawyers.[85] Until the 1980s, the traditional degree for a London banker was classics (Greek and Latin language and history). A background in classics, or having served as an officer in a good regiment, were considered good training for banking, as banking was perceived to be about prudence and judgment, qualities seen to be promoted by the study of history or through officer training.

Today an investment bank, or the investment banking arm of a commercial bank, is typically filled with ultra-numerate people with little knowledge of history or the humanities. In their worldview, markets and corporations exist primarily to produce profits, not to serve their customers and communities. Most of their remuneration is by way of an annual bonus, and they see the world through a quantitative/analytical lens, not a human one.

Furthermore, what a bank actually ‘does’ has changed profoundly. Banks in 1970 essentially intermediated money. They received deposits and made loans. In contrast, investment banks and investment banking arms of major commercial banks derive relatively little of their current income from financial intermediation, and far more from speculating on markets, underwriting stock and bond issuances, etc.

To reiterate, a banker travelling forty years into the present would not recognise much of what a bank does today. Indeed, as seen above, much of the business of a contemporary bank would have been illegal in 1970.

The G20 reforms as a response to the profound changes in the global financial system

All of the G20 reforms are worthwhile. Some, such as Basel III, were in train anyway, but even those that were not are still beneficial. A more significant question is whether the reforms address the fundamental changes in the system. The only ones on target to do this relate to credit rating agencies (CRAs) and remuneration, but the G20’s proposals in these areas don’t go far enough. The reforms actually needed are analysed below.

Reforms to credit rating agencies

The G20’s proposed CRA reforms are inadequate. The fact that the issuer pays for the rating gives rise to a powerful and distorting conflict of interest. US Senator Al Franken has proposed to remove this conflict by authorising the Securities and Exchange Commission (SEC) to establish an independent panel that assigns the ratings of structured products (not of companies or sovereigns) to the CRA, the panel believed was best equipped to provide the rating. The financial incentive to provide a favourable rating to continue to get an issuer’s business would thus be removed.[86] Moreover, if the G20 were serious about reforming CRAs, it would mandate a global requirement along these lines and then extend it to all ratings, not just structured products.

Banker remuneration

The G20’s commitments to reforming banker remuneration were advanced by the Europeans, and have achieved most saliency in the EU in terms of scope, scale and implementation. The European Union has agreed to limit bankers’ bonuses to a year’s salary, or two years’ salary with the approval of at least 66 per cent of shareholders holding at least 50 per cent of the shares. To encourage bankers to take a long-term view, a minimum of 25 per cent of any bonus exceeding one year’s salary must be deferred for at least five years. EU countries need to implement the rules nationally by 1 January 2014. The agreement is designed to curb the culture of excessive bonus payments that encouraged risk-taking for short-term gains that contributed to the financial crisis.[87]

These changes come on top of the rules European regulators announced in December 2010 that require banks to defer at least 40 to 60 per cent of bonuses for three to five years and pay at least 50 per cent of bonuses in shares (rather than cash) and publish pay details for senior management and risk takers.[88]

Bonuses often represent 80 per cent or more of total remuneration. If shareholders approve bonuses of up to two years’ salary, that will water down the effect of these changes, and if they hold the line, this will be a major change. Bankers will derive more of their income in fixed salary form, and less in bonus, which should encourage less risk taking.

The proposed remuneration caps are a step down from earlier restrictions that required at least one-half of bonuses to be paid in shares, deferral of the payment of much of the bonus for three to five years, and making bonuses subject to ‘claw back’ provisions. Nevertheless, the revised caps do represent a change if the regulators are sufficiently vigilant and insistent to bring them about, which would do much to change risk-taking behaviour. Given the culture of banks, refusing to pay a banker part or all of a deferred bonus - because assets they created or acquired prove to be of far less value than was anticipated - would be a major cultural change. With the two sets of bonus reforms that have been agreed upon, we may well see different banker behaviour in the EU in five years’ time.

Steven Bardy[103]

Introduction

The post-crisis regulatory architecture has seen a significant change in the role and standing of securities regulators globally, particularly the International Organisation of Securities Commissions (IOSCO).

Before the Crisis, IOSCO was seen as providing guidance and standards, bringing together and summarising regulatory approaches at both national and regional levels. It had a limited profile outside of the securities regulatory community.

The crisis — and the architecture established around the FSB and the G20 — has changed this. IOSCO played a key role in responding to the crisis by providing policy guidance and standards in new areas of regulation. Examples include OTC derivatives regulation, the regulation of financial markets infrastructure, the regulation of commodity futures markets, oil price reporting agencies and the regulation of shadow banking (for instance, securitisation and money market funds). Each of these initiatives was either taken at the request of, or in conjunction with, the FSB or the G20. IOSCO is, as a result, now seen by policy makers as — and indeed sees itself as — a standard setter for financial services and market regulation.

The benefits of the new architecture

The new regulatory architecture has also led to important changes in how standards and guidance are developed. Specifically:

• There has been a marked improvement in the speed with which IOSCO has developed standards and guidance. The creation of the FSB has increased the amount of pressure to develop guidance and standards in significantly tighter timeframes than had been IOSCO’s practice.
• There has also been greater pressure to develop more granular and useable guidance and standards than had been IOSCO’s practice. An example is the ‘Principles for Financial Markets Infrastructure’ and related methodology;
• It has provided a platform for IOSCO to engage on a regular basis and cooperate with standard setters from other sectors in developing cross-sectoral responses. Examples have included the financial regulatory community’s work on securitisation, OTC derivatives, Financial Market Infrastructure, identification of systemically important institutions and (more generally) shadow banking;

Opportunities for improvement

The basic parameters of the current architecture and how it operates are sound — although some concerns remain which key financial regulators believe should be addressed.

Concerns to be addressed include the following -

• Respecting the roles and responsibilities of Standard Setting Bodies (SSBs): concerns remain about the FSB extending its coordinating and oversight role into standard setting in areas that are the traditional remit of the SSBs. The work on global systemically important banks (GSIBs) and shadow banking are examples. The FSB should respect — and not seek to replicate — the expertise of the SSBs.
• Scope creep: concerns also remain that the FSB is moving beyond its financial stability mandate. Initiatives in the audit and consumer protection have been recent examples;
• Effective G20 oversight: although the G20 has provided both the FSB and SSB’s with useful and appropriate guidance, it has tended to act as an uncritical rubber stamp of the FSB’s work. It should aim to challenge the FSB in the work it does;
• Ensuring the case for action is carefully made out — before initiatives are taken: the FSB has an important role to play in challenging the need for regulatory action and undertaking a high level cost-benefit analysis before work is started. This should also apply to initiatives proposed by the G20. This will assist in managing unintended consequences.
• Understanding the cumulative impact of SSB initiatives. The FSB’s work to date has played little heed to the need to understand the impact of the SSB initiatives it oversees — as those initiatives are being undertaken. The FSB is well positioned to monitor and assess cross-sectoral impacts and should do so. It is one thing to explore the impact of initiatives after they have been taken. It is quite another to monitor those impacts as initiatives are designed. The FSB should work with SSBs to ensure engagement through the development and guidance of standards.
• Improved engagement with industry. One of IOSCO’s great strengths is the way it engages with the regulated population. Industry’s views are an important input into every IOSCO project, with views being expressed through formal consultation processes and through industry round tables. IOSCO has also recently developed and refined processes for dialogue at a strategic level, including periodic stakeholder consultation meetings and participation by industry leaders in roundtables preceding our Board meetings. FSB would benefit from similar ongoing dialogue processes with industry representatives. Industry has expressed concern that it has only been able to engage with the FSB at the late stages of developing guidance and standards. It has had little say into whether and how particular projects are undertaken. Industry argues that the absence of consultation contributes to a lack of pragmatism in FSB proposals.

The 2014 agenda

The Agenda for next year should be about consolidation and refocus. Rather than pursuing new initiatives we should take a deep breath and reflect on the work done to date. Specifically:

• We should focus on supporting orderly implementation of work to date. The FSB should act as a forum and provide guidance about how the implementation of global standards, at national and regional levels, is knitted together. This will involve building on the monitoring work already in train, but also developing guidance and approaches to how national laws, that won’t always be the same, can work together.
• We should review the work we have done to date. We need to assess the cumulative impact of our work and adjust and tweak it to address any unnecessary burdens.
• We should review how we do our work. We need to ensure early impact assessments are a key part of international standards and policy development.
• We need to think about balancing our focus on stability with the economic impact of our recommendations. G20 and FSB processes also need to recognise the role capital markets can and should play in building recovery as an adjunct or alternative to finance sourced through conventional banking channels.

Steven Bardy

Steven is responsible for managing ASIC’s engagement in international policy forums, including IOSCO and advising the Commission on the implications of international regulatory developments. He is Chairman of the IOSCO Assessment Committee, and supports the ASIC Chairman as Chairman of the IOSCO Board and member of the FSB Standing Committee. Steven has played an active role in a number of recent IOSCO projects, including revision of the ‘Objectives and Principles of Securities Regulation’, systemic risk, OTC Derivatives, benchmarks and cross-border regulation. Steven has also worked as a solicitor with a major international law firm, ministerial advisor, academic, management consultant and in senior risk roles for a major Australian Bank. He holds Economics and Law degrees from the ANU. He has also completed an LLM in constitutional and international law at Queens University Canada and an MBA from the London Business School in international finance.

Ross Buckley

Professor Ross Buckley is the CIFR King & Wood Mallesons Professor of International Finance and Regulation, and a Scientia Professor, at the University of New South Wales. His principal fields of research are international financial regulation and international economic governance. He is a series co-editor of the International Banking and Finance Law Series and the Global Trade Law Series of Wolters Kluwer of The Hague and has published broadly in Australia, Canada, China, England, Germany, Hong Kong, Japan, Singapore and the U.S. He has consulted to government departments in Australia, Indonesia, Vietnam and the US. He has twice been a Fulbright Scholar (at Yale and Duke) and many times a half-bright scholar.

Mike Callaghan AM, PSM

Mike Callaghan is the Director of the G20 Studies Centre at the Lowy Institute and editor of the G20 Monitor. Prior to taking up this position, Mike was Executive Director, International, in the Australian Treasury and Australia’s G20 Finance Deputy. He was also the Prime Minister’s Special Envoy on the International Economy. From 2005 to 2007, Mike was Executive Director, Revenue Group in the Australian Treasury In 2006 he was appointed by the IMF Managing Director and the President of the World Bank to an eminent persons group to report on improving cooperation between the World Bank and the IMF. From 2000 to 2004 Mike was Executive Director at the International Monetary Fund, Washington DC Mike has served as Chief of Staff to the Australian Treasurer, the Hon Peter Costello. He joined the Treasury in 1974 and has held a variety of senior positions, including heading the Economic Division and the Financial Institutions Division. He has economic and law degrees from the Australian National University and is a graduate from the Royal College of Defence Studies, London.

Richard Gray

Richard joined Westpac in early 2011 and heads the bank’s Office of Regulatory Reform, evaluating all international regulatory developments on behalf of the bank. Richard commenced his career as a corporate investigator at ASIC. He then moved into the private banking sector and over a diverse twenty-five year career he has held senior positions at AIDC, Societe Generale and Goldman Sachs JBWere. During that time he established business units and ran teams engaged in corporate and project finance, structured finance, infrastructure advisory, debt origination, capital markets and specialised funds management.

Graham Hodges

Graham Hodges is Deputy Chief Executive Officer at Australia and New Zealand Banking Group Limited. Prior to this role, Graham was Chief Executive Officer, New Zealand and a director of ANZ National Bank Limited, responsible for the running of ANZ Group's New Zealand business. He was also acting Chief Executive Officer for Australia in 2009. Graham has held the positions of Group Managing Director, Corporate, Managing Director, Small to Medium Business and Head of Corporate Banking for Australia and New Zealand. Other prior roles with ANZ include State Manager, Business Banking for Victoria and Tasmania; and Regional Executive, Business Banking Melbourne. In 1995, Graham led a project team, which designed and rolled out a customer profitability tool for the Business and Institutional Bank. Graham joined ANZ in 1991 and was appointed Chief Economist in 1992, a post he held for three years. Before ANZ, Graham spent several years with the International Monetary Fund in Washington DC and nine years in Commonwealth Treasury in Canberra. Graham has a Bachelor of Economics (Hons) from Monash University.

Hugh Jorgensen

Hugh Jorgensen is a Research Associate with the G20 Studies Centre at the Lowy Institute, where his work focuses on economic, political and governance aspects of the G20 agenda. He holds a double degree in Economics and Arts (Political Science/International Relations) from the University of Queensland and was awarded first class honours for his thesis on ‘the institutional evolution of the G20 post the global financial crisis.’ Hugh has previously worked as a researcher for an ARC-funded comparative banking project (looking at the pre- and post-crisis experience of banks in Australia, Canada, the United States and the United Kingdom), as a project spokesperson for the United Nations Department of Public Information and as a tutor of globalisation and international political economy.

Stephen Pickford

Stephen Pickford is a Senior Research Fellow at Chatham House, London. From July 2007 to January 2010 he was managing director, international and finance, at the Treasury in the United Kingdom. He previously served in a number of roles in the Treasury, including director for Europe, and director for international finance. Between 1998 and 2001, he was the United Kingdom’s executive director at the IMF and World Bank.