The description of Regulatory networks are particular interesting. According to Slaughter, regulatory networks emerged because of shared responsibility for transnational financial entities. These networks are concentrated around EU- and OECD-countries (in the field of financial regulation maybe it’s better to speak of BIS-networks).

She also distinguishes three different kinds of transgovernmental networks: government networks within international organisations (within the UN), within an executive agreements (G7) or spontaneous government networks which sometimes became institutionalized. She also distinguishes Information Networks, Enforcement Networks (which sometimes leads to capacity building) and Harmonization Networks.

The book tries to explain how increased transgovernmental networks help to solve the dilemma of needing increased cooperation between goverments on global problems with an increased scepticism against a global government. She also points to the dilemmas of criticism of transgovernmental network. For instance, the increased demand for accountability to domestic political groups might reduce the ability of transgovernmental networks to solve global problems.

The overview-report looks at the problems identified by the G8 Action Plans, Task delegated to various institutions and results given from the implementation report. It is subdivided into ten sections:

• General Provisions
• Market Infrastructure
• Securitization Markets
• Public Debt Management
• Broadening and Diversifying the Investor Base
• Developing of derivative and swap markets
• Promoting Regional Initiatives
• Broadening the Database
• Developing bond markets in less-developed countries (especially Sub-Saharan Africa)
• Techical Assistance

The G8 Action Plan was mentioned in the recent report of the G8 Finance Ministers Meeting in Osaka, Japan, but also in various other conferences:

• High Level Workshop 2007 Developing Bond Markets in Emerging Market Economies, Frankfurt, May 10, 2007
• G8 Conference on Bond Markets in Emerging Economies and Developing Countries, Frankfurt, 31 January 2008
• Second OECD Forum on African Public Debt Management, 12-13 December 2007, Amsterdam
• World Bank Debt Management Stakeholder’s Conference, Oslo Norway, March 5-6 2008

A list of further documents can be found in the report, further entries will be added in the future.

The chart (left) lists 21 international organizations. Some of them are grouped together to reduce the overlap. The organizations are clustered along four categories:

• informal government-institutions (blue): G5, G7, G8, G22, G33, G20, G24
• formal government-institutions (yellow): OECD, FATF, Paris-Club, World Bank, IMF
• central-bank-institutions (red): G10, CPSS, CGFS, BIS
• regulator institutions (green): FSF, BCBS, Joint Forum, IOSCO, IAIS

All institutions operate on the international level.

The power-ranking (below) lists the countries according to their membership in crucial institutions. The power-rank is calculated by assigning equal value to all organisations and then distributing the value across the members of an organisation. A country is more “powerful” if it is a member of a more exclusive group of nations.

The countries can be grouped into six categories:

• W1: The Group of Seven (G7): This premier league of Developed Western Economies can be subdivided into two groups:
  • The Group of Five (G5): France, Germany, Japan, United Kingdom, United States
  • The Two Add-Ons: Canada, Italy
• W2: Second league of Developed Western Economies: Netherlands, Switzerland, Belgium, Sweden, Australia, and Spain.
• W3: Third league of Developed Western Economies: Luxemburg, Denmark, Poland, Finland , Ireland, Norway, New Zealand, and Austria
• E1: The Emerging Ten: The premier league of emerging economies can subdivided into three groups:
  • BRICS+05: Russia, Mexico, Brazil, China, India, South-Africa
  • The Two Key Capital Markets: Singapore, Hong Kong
  • The Two Emerging Aspirants: Argentina, South Korea
• E2: Second league of Emerging Economies: Turkey and Indonesia
• E3: Third league of Emerging Economies: Malaysia, Thailand, Saudi-Arabia, Greece, Egypt, Chile, Philippines, Morocco, Venezuela and Côte d’Ivoire.

Main findings

• The dominance of the G5 and the G7 in the international institutions can be clearly found in the institutional membership.
• Russia is quite unlike the G7, is not a full member in the financial institutions, and without G8 membership its rank would be significantly lower.
• China and Hong Kong together rank higher than all members of the W2, the second league of Western developed countries. In other words, China and Hong Kong together have more influence in international institutions than for instance the Netherlands, Switzerland or Belgium.
• Mexico, Brazil, China, India, South Africa, South Korea and Argentina are all good candidates for G8 enlargement when considering institutional membership. South Korea and Argentina are however impeded by the relative dominance of Mexico, Brazil, and China in international institutions. South Africa and India are less influential than South Korea and Argentina in terms of institutional membership.
• The main difference between the first (W1) and second (W2) league of developed economies is membership in the FSF and in the G20.
• The main difference between the second (W2) and third (W3) league of developed economies is participation in BIS-hosted institutions.
• The main difference between W3 and E3 is that E3 was a member of the G33 whereas W3 participates in the OECD.
• There is considerable overlap of membership in the BIS-hosted institutions and in the OECD-FATF-Paris-Club-Cluster.
• The BIS-hosted cluster of institutions, unlike the BIS itself, does not grant extensive membership to the emerging economies, with the exception of Hong Kong and Singapore.

W1: G5 and G7

The dominance of the G5 countries (US, UK, G, F, J) can be seen in both the chart and the ranking. The G5 are members in all institutions (with the exception of the G24) and often play a dominant role in the various institutions.

The two remaining members of the G7, Canada and Italy, play a similar important role in most of these institutions. Yet in contrast to the G5, they do not have exclusive positions in the IMF/World Bank Board of Governors/Directors.

Canada and Italy participate in only two out of three of the working groups in the Joint Forum, whereas the G5 participates in all three working groups. (The Joint Forum is a forum for discussing financial conglomerates, bringing together regulators with the three main international regulatory bodies, BCBS, IOSCO, and IAIS in three working groups, Banking, Insurance and Securities.)

E1: BRICs and O5

Russia is a member of the G8, but clearly does not fall into the same category as the G7 in terms of institutional membership. For historic but also for economic reason is it not member of the G10, which is a forum of central banks and finance ministers of major financial markets.

Russia does not contribute to the various Committees hosted by the BIS, such as the CPSS, CGFS, the BCBS or the Joint Forum. Russia was invited to join the OECD, actively participates in the FATF and the Paris Club. The fact that Russia does not belong to G7 is confirmed by the continued tradition of the G7 Finance Ministers still meeting without Russia, except in the meeting ahead of the G8-Summit.

Russia is often grouped with other emerging economies, such as China, Brazil, and India (the so-called BRIC countries) or the so-called O5 (Outreach Five: Brazil, Mexico, India, China, South Africa). In the power-index, these six countries can all be found in the upper-half of the index, but occupy very different ranks (Russia: 13th, Mexico: 14th, Brazil: 16th, China: 19th, India: 21st, South-Africa: 23rd).

The common characteristic of these six countries is their membership in all forums attempting to bring together emerging economies and the developed economies, such as the G22, the G33 or the G20. This confirms the “bridge position” that these six countries maintain to the developing world. Brazil, India and Mexico are also member of the G24, a group of developing countries discussing financial matters, China is only an observer of that group.

A common characteristic of these six countries that they lack participation in the BIS-hosted bodies, especially they are not members of the CPSS or the CGFS. Brazil, China, India, and Mexico have been consulted by the CGFS occasionally. All six countries are member of the BIS, but only Mexico and China have seats on the Board of Directors, which gives them slightly more impact on the BIS activities.

Mexico is the only country which is a full member of the OECD, although Brazil, China, India, Russia and South Africa have been invited to join. With the exception of India, all countries are member of the FATF, a task force for fighting money laundering and financing of drugs.

They are all members of IOSCO and IAIS, but only Brazil and South Africa have gained seats on the Executive Council.

W2 vs. E1: G8 Enlargement

When looking at these six countries, two questions should arise: are they really suitable candidates for G8 enlargement? And are there other more suitable candidates?

Russia occupies a high position in the ranking but mostly because of its membership in the G8. Without the G8 membership, it would fall from the 13th to the 20th rank.

Mexico (14th) and Brazil (16th) clearly earned their position in the global financial architecture, and thus among the emerging economies of E1 are the first candidates to be considered for G8 enlargement.

Nevertheless, they are surpassed by the develped countries occupying the upper-third of the ranking (W2). These are developed, medium-sized Western Economies such as Netherlands (8th), Switzerland (9th), Belgium (10th), Sweden (11th), Australia (12th), and Spain (15th). In the past, these countries complained that the G7 weakens their institutional power by not engaging with them more. Nevertheless, their strength is clearly reflected in other forums, such as the BIS-hosted bodies. However, the reason why the W2 have not been invited to the W1 is clearly that they would not bring much diversity to the table of the G7, but make decision-making more difficult, thus it is unlikely that they would ever be candidates for G8 enlargement.

China (19th), India (21st) and South Africa (23rd), however, are surpassed by other emerging economies, such as Singapore (17th), Hong Kong (18th), Argentina (20th), and South Korea (22nd), which are also part of the E2.

The high-ranking of Singapore and Hong Kong reflect their status as important financial markets in the Asian region, which is why they are also members of the Financial Stability Forum.

China is not a direct member of the FSF, but indirectly through Hong Kong. If Hong Kong and China are counted as one entity, instead of two separate entities, than “ChinaHongKong” would occupy the 9th position in the ranking, far ahead of the Netherlands and all other countries that follow.

Why are Argentina and South Korea often ignored in G8-enlargement debates, while India and South Africa are mentioned? In terms of membership in international institutions, all four have similar characteristics like the above mentioned BRICS/O5. They are members of the G20 (and the G22+G33). Argentina is also member in the G24, Korea has been consulted in the CGFS. Argentina has not been invited to the OECD, but Korea is a full member. Argentina is a member in the FATF, Korea is not. Argentina is a member of the Executive Council of IOSCO, Korea is a normal member in IOSCO. But in terms of institutional membership they can clearly match India and South Africa.

India and South Africa are most likely to be chosen for G8 enlargement for geopolitical balance. India represents a large fraction of Earth population, whereas South Africa is the most developed country in Africa (other countries in Africa, like Egypt (38th), Morocco (41st) and Côte d’Ivoire (43rd), occupying position at the lower end of the ranking). Argentina is overshadowed by Mexico and Brazil, whereas South Korea is overshadowed by China, Hong Kong and Singapore in South-East Asia.

W1 vs. W2: FSF- and G20 participation

What distinguishes the group of “old developed economies” (W2) from the G7 (W1)? The Netherlands (8th), Switzerland (9th), Belgium (10th), Sweden (11th), Australia (12th), and Spain (15th) occupy ranks on the top-third of the scale. Only Australia is a member of the G20 and the G22, but all are member of the G33.

Except for Spain and Australia, all are members of the G10, the CPSS, the CGFS (Spain and Australia have been consulted by the CGFS). Belgium, Spain and Sweden are not members of the FSF, Australia, Netherlands and Switzerland send one delegate to the FSF (contrasted with three delegates sent by G7).

All countries of the W2 are full members of the Paris Club, the OECD, the FATF, the IMF and World Bank, but do not dominate these organisations.

Australia is not a member of the BCBS, all other five W2 countries are. Sweden is not a member of the Joint Forum, all others are, with Australia having the most impact as being member of two working groups. Australia and Spain occupy executive positions IOSCO (Spain because IOSCO’s headquarters are in Madrid), all six are members of IOSCO and IAIS.

Thus the main difference between W1 and W2 is the FSF- and G20-participation. The ranking suggests that these countries were deliberately given a weaker-status or excluded from membership by the G7, because again they would add little diversity to the table but make decision-making more difficult. The W2 have impact through the BIS-hosted institutions

W2 vs. W3: BIS-Participation

The second league of developed countries must be contrasted with eight other developed countries (W3) which occupy the lower half of the ranking of the 43 countries, such as Luxemburg (24th), Denmark (26th), Poland (27th), Finland (29th), Ireland (30th), Norway (31st), New Zealand (32nd), and Austria (33rd).

These countries are mostly not members of the G22, G33 or G20 (except for Poland, who was a member of the G33 and the G22, but was not chosen for the G20).

They are members of the BIS (with the exception of Luxemburg), but do not have seats on the Board of Directors. None of them however are systemically important to be members of the FSF or the BCBS (with the exception of Luxemburg, who is a member of the BCBS even though it is not a member of the BIS). Only Denmark participates in the Joint Forum, the other ones do not.

They are members of the Paris Club (with the exception of Luxemburg and Poland), all are members of the OECD, FATF, IMF and World Bank. Only New Zealand and Poland have an Executive Position in IOSCO, but all are members of IOSCO and IAIS.

E2 vs. W3: G20 and OECD participation

Turkey (25th) and Indonesia (28th) can be found in similar position as the above mentioned W3. However, both Turkey and Indonesia have become members of the G20, in contrast to the W3. They are not members of the OECD or the FATF, but Indonesia has been offered enhanced engagement in the OECD (for the ranking, enhanced engagement and invited membership is given the same weight).

Neither Turkey nor Indonesia are member of the FSF or the BCBS, thus the main difference to the group above is their membership in the G20 or in the OECD. It would be fruitful to study whether G20 or OECD membership adds more power capability in terms of institutional membership.

E3: Occasional participants in international financial institutions

The last group to be discussed is a group of developing countries occupying the lower ranks: Malaysia (34th), Thailand (35th), Saudi-Arabia (36th), Greece (37th), Egypt (38th), Chile (39th), Philippines (40th), Morocco (41st), Venezuela (42nd) and Côte d’Ivoire (43rd).

Malaysia and Thailand were members of the G22 and G33, but not members of the G20. Egypt, Philippines and Venezuela were members of the G24, but not in the G22 or G20 (although Egypt was member of the G33).

None of the eight are important members of BIS-hosted organisations, although Chile, Greece, Malaysia, the Philippines, Saudi-Arabia and Thailand are members of the BIS.
Greece is a full member of the OECD and the FATF, Chile has been invited, the other countries in E3 are not members.
All of them are members of IOSCO and IAIS, with the exception of Saudi-Arabia, Venezuela (only member of IOSCO) and Côte d’Ivoire.

Why include countries like the E3 in the ranking at all? With the exception of Côte d’Ivoire, all countries of E3 are important economies in their region, but this is not reflected in the institutional membership.

• Saudi-Arabia is not a member of BIS or BIS-hosted bodies, it is not a member of IOSCO and IAIS, not a member of the OECD, the FATF or the Paris Club, but a member of the G33.
• Venezuela has been included in this ranking because it is a member of the G24.
• Côte d’Ivoire has been included in this ranking because it was a member of the G33.

There are probably other countries in their respective regions which would earn a higher ranking if included.

Relationship between memberships in various institutions

In the sample of 43 countries, there are some clear relationships between memberships in the various institutions. The most obvious is that all members of the G5 are members of the G7, all members of the G7 are members of the G8, all members of the G8 are members of the G22, G33 and G20 (this is the dominance of the G5/G7 describe earlier).

G24 members are not members of the G8 and vice versa, but 5 members of the G24 are also in the G22, G33, and G20. G24 members are not members of the G10, the CPSS, the CGFS and, with the exception of Mexico, they are not members of the OECD.

When turning to the regulator-institutions and central bank institutions, it is obvious that all G7 members are G10 members, all G10 members are members of BIS, CPSS, CGFS, BCBS, OECD, and FATF.

In fact, not only is the G10 members of the BIS-hosted institutions, the G10 has not added many other countries to these institutions. The CGFS consists of the G10 plus Luxemburg (not a BIS member), the CPSS of the G10 plus Hong Kong and Singapore, the BCBS of the G10 plus Spain.

There is also considerable overlap between the G10 and other instutions hosted by the BIS. Out of the eleven G10 members, only Belgium and Sweden do not participate in the FSF, but the FSF includes Hong Kong, Singapore and Australia.

The Joint Forum includes the G10 with the exception of Sweden, and includes Australia and Denmark.
Seventeen countries are the most relevant players in the BIS-hosted organisations: the G7 (Rank 1-7), Netherlands (8th), Switzerland (9th), Belgium (10th), Sweden (11th), Australia (12th), Singapore (17th), Hong Kong (18th), Luxemburg (24th) and Denmark (26th). None of the emerging economies, despite being members of the BIS, participate in these BIS-hosted institutions.

The vast majority of BIS-members in the sample are also members of IOSCO and IAIS.

Memberships also overlap with regard to the governmental organisations in Paris: the Paris Club, the OECD and the FATF. All members of the Paris-Club with the exception of Russia are members of the OECD. Russia has been invited to the OECD, however. All members of the OECD, with the exception of South Korea actively participate in the FATF. And all members of the FATF, like all other states in our sample are members of the IMF and the World Bank.

Further research

The index has tried to focus on groups relevant to the Financial Architecture, but clearly other institutions could be included. In the area of trade, for instance the G77, the WTO, the Trade-G33, the Trade-G20, the Quad-Group would be relevant. In the area of security policy, the Security Council as well as the P5 (five permanent members in the Security Council), as well as the OSCE could be relevant. In the field of energy, group membership in the OPEC or the IEA needs to be included. Also regional institutions, such as APEC, ASEAN, EU or AU can be incorporated.

Since the index is only a first attempt to get a grip on how group membership affects power, further research would also incorporate different weights for the organisations, maybe differentiated along categories of attendance – head of states, ministers, deputies, working group etc. and policy field.

Procyclicality is used in the context of discussing the effects of Basel II on the financial system. A simplified definition of pro-cyclicality is:

International rules have encouraged banks to act more aggressively when the economic cycle is in the middle of an upswing, when some argue that is precisely when they should be putting money away for a rainy day. The global economy has become more volatile as a result. Source: Thisismoney.co.uk

Claudio Borio, Craig Furfine and Philip Lowe express the same statement in more sophisticated words:

Financial developments have reinforced the momentum of underlying economic cycles, and in some cases have led to extreme swings in economic activity and a complete breakdown in the normal linkages between savers and investors.

These experiences have led to concerns that the financial system is excessively procyclical, unnecessarily amplifying swings in the real economy.

In turn, these concerns have prompted calls for changes in prudential regulation, accounting standards, risk measurement practices and the conduct of monetary policy in an attempt to enhance both financial system and macroeconomic stability. Source: Claudio Borio, Craig Furfine and Philip Lowe in “Pro-cyclicality of the financial system and financial stability: issues and policy options“

José Viñals, Director General International Affairs at the Banco de Espagna, reminds us that a certain procyclicality of the financial system is wanted, but excessive procyclicality can be a burden:

In the financial sphere, a certain degree of procyclicality is a natural, sensible and desirable outcome as it reflects the extent to which the financial sector is influenced by developments in the real economy and viceversa. The issue is nevertheless to what extent there is an excessive degree of procyclicality. The financial system is excessively procyclical when it unnecessarily amplifies swings in the real economy and/or reduces the stability and soundness of the financial sector. Source: José Viñals in “Procyclicality of the financial system and regulation“

Indicators of pro-cyclicality

According to Claudio Borio, Craig Furfine and Philip Lowe periods of growth are often associated with:

• significant increases in the ratio of credit to GDP
• large increases in equity and property prices
• decreasing bond spreads between corporate and government securities
• credit rating agencies failing to predict changes in the probability of crises
• unaltered bank provisions
• increasing bank profitability and increasing bank equity prices

Source: Claudio Borio, Craig Furfine and Philip Lowe in “Pro-cyclicality of the financial system and financial stability: issues and policy options“

Causes of Pro-Cyclicality in the financial system

Nancy Masschelein, from the National Bank of Belgium, has listed various sources of pro-cyclicality. Source: Nancy Masschelein in “Monitoring pro-cyclicality under the capital requirements directive : preliminary concepts for developing a framework“

1. Fluctuations in the quality of banks’ and borrowers’ balance sheets.An increase in bank profits during periods of growth supports the extension of credit, while decreasing bank profits due to defaulted loans reduce this extension of credit. At the same time, a recession causes declining profits, increases demand for new credit and increases the interest rates.Claudio Borio, Craig Furfine and Philip Lowe have labelled this the Incentive Explanation. Source: Claudio Borio, Craig Furfine and Philip Lowe in “Pro-cyclicality of the financial system and financial stability: issues and policy options“
2. Information asymmetries between borrowers and lenders.During periods of growth, the value of collateral rises and borrowers with riskier projects can find lending. Under recessions, due to the decreased value of collateral, even borrowers with very profitable projects will find it difficult to obtain funding. These cyclical effects are especially relevent for borrowers which are more prone to asymmetric information effects (such as SMEs).Claudio Borio, Craig Furfine and Philip Lowe call this explanation the Financial-accelerator-explanation. Source: Claudio Borio, Craig Furfine and Philip Lowe in “Pro-cyclicality of the financial system and financial stability: issues and policy options“.
3. Inappropriate responses by participants in the financial system and lack of institutional memory.Euphoric expectations which arise from an investment boom driven by the business cycle or a disaster myopia which shows in a reduced subjective probability of a major shock if the last shock has already a few years past, is another source of excessive lending by banks during periods of growth.Allen N. Berger and Gregory F. Udell raise the problem of a lack of institutional memory. Source: Allen N. Berger and Gregory F. Udell in”The Institutional Memory Hypothesis and the Procyclicality of Bank Lending Behavior“
   

   Under the institutional memory hypothesis, as time passes since the last “learning experience” with problem loans – the last time that the bank suffered a loan “bust” – loan officer skills decline.

   Part of this decline in lender ability is attributable to a proportional increase in inexperienced lenders who have never had such a “learning experience.”

   Part of the decline in lender ability is also due to the atrophying skills of experienced loan officers as time passes since they last addressed significant loan problems.

4. New financial innovative instruments.The use of new financial instruments facilitated the spreading and the diversification of credit risks and increased the possibilities of hedging. In favourable circumstances, banks can easily transfer credit risk using innovative credit risk transfer (CRT) products, which could induce banks to increase lending as credit risk can be transferred.

Regulation and pro-cyclicality

The most important dimension of pro-cyclicality that is being adressed in the remaind of this article is regulation. Minimum capital requirements imposed by regulators to reduce systemic risk from collapse of systemically important financial intermediaries may force banks to reduce lending in an recession, increasing the above pro-cyclical mechanisms of the financial system.

George G. Pennacchi warned that Basel II increases the sensitivity of a bank’s capital requirement to the risk of its assets and creates incentives which make bank lending more procyclical.

During recessions, loan losses reduce bank capital and, even if capital requirements are insensitive to risk, a capital-deficient bank must increase its capital ratio. In addition, recessions tend to raise the default risk of loans, and Basel II’s more refined risk-based standards would further pressure banks to strengthen their capital ratios. This response of capital ratios to default risks can reduce banks’ incentives to lend during a recession and worsen economic activity. Thus, capital requirements as envisioned under Basel II increase macroeconomic instability.Source: George G. Pennacchi, Journal of Financial Intermediation “Risk-based capital standards, deposit insurance, and procyclicality“

Besides miminum capital requirements, there are other ways that regulation can increase pro-cyclicality. Philipp Turner has listed them and discussed their relevance. Source: Philipp Turner in “Procyclicality of Regulatory Ratios?“

1. Timing of tightening of capital rulesDuring and immediately after a financial crisis, policy-makers have large incentives to tighten bank regulation which further curtails bank lending. Turner says that this problem is not that revelant in practice, most countries allow a phase-in period for the tightening of prudential ratios or in dealing with generalised problems.
2. Regulatory bias in favour of short-term lendingUnder Basel I, international interbank lending of up to one year maturity had a 20% risk-weight irrespective of country, but lending of more than one year to non-OECD countries carried a 100% risk weight which would make bank lending to emerging markets “too” short term. According to Turner, Data does not suggest that this effect is important, nevertheless Basel II adresses these ambivalent distinctions.
3. Cyclicality of minimum capital ratiosThis will be discussed later in this article in relation to bank provision and IAS 39, but the general idea is that because of certain minimum capital rations banks will reduce lending to meet the required minimum capital rations, if they have not made sufficient provisions for losses.
4. Cyclicality of capital ratios due to the use of external credit ratingThis will also be discussed later in relation to the impact of Basel II on risk management in banks, but the general idea is that an increased reliance on external credit rating in determining risk weights can lead to the necessity for increased capital ratios in times of recession.

Basel II, Credit Rating Agencies and Pro-Cyclicality

According to José Viñals the philosophy of modern monetary politics and approaches to financial stability incorporated in Basel II is quite similar:

• both are forward-looking in nature and have a medium-term horizon
• both have an anticipatory character that seeks prevention rather than cure
• both attempt to incorporate market views through the role played by expectations and market discipline.

He argues that Basel II reduces pro-cyclicality by improving banking supervision.

By contributing to a better assessment and management of risks, Basel II should reduce the scope for surprises and thus for procyclicality.Source: José Viñals in “Procyclicality of the financial system and regulation“

The influence of Basel II on the real economy would work along the following mechanism

Basel II would increase the risk-sensitiveness of minimum capital requirements which, in turn, would lead to higher cyclicality of the overall regulatory capital and to more procyclical capital. Consequently, this would be reflected onto more procyclical lending and onto a higher degree of procyclicality in the real economy.Source: José Viñals in “Procyclicality of the financial system and regulation“

The influence on Basel II on the real economy through capital requirements is the reliance on external credit assessment for calculating risk weights. Philip Turner states that under Basel I, risk weight for sovereign and corporate debt were based on OECD membership wich was not sufficiently responsive to risk. Basel II relies more on “credit assessment agencies”, so not only credit-rating agencies, but also export insurance agencies, credit registers, market data.

However, credit rating agencies are often more backward-looking rather than forward-looking, their assessments are strongly negatively correlated with the real effective exchange rates, even though depreciation in the wake of a crisis should not lead to a downgrade but to a recognition of medium-term strenght due to a more competitive exchange rate.Source: Philipp Turner in “Procyclicality of Regulatory Ratios?“

Eva Catarineu-Rabell, Patricia Jackson and Dimitrios P Tsomocos more specifically identify the choice of rating system as an important element in pro-cyclicality:

The proposed new Basel Accord, in contrast to the Current Accord, makes provision for time varying risk weights for individual loans. Although the Basel Committee will set fixed weights for loans with a given probability of borrower default, banks will choose the probability of default band into which a loan will be slotted.

It then becomes very important how the banks carry out this ‘slotting’. When banks assess a borrower’s probability of default the assessment can be based on current economic conditions (where the rating will be conditioned on the point in the cycle) or can take into account the effect on the borrower of a possible adverse change in the climate. [...] The new element under Basel II is the additional procyclicality which will come from the latter element. [...]

Strongly procyclical capital requirements could cause severe macro economic effects by creating credit crunches in recessions, thereby exacerbating the economic downturn. They could also encourage excessive lending in booms. An important policy issue is therefore whether banks would choose to adopt more stable ratings across the cycle, which would moderate the procyclical effects, or whether they would adopt ratings conditioned on the point in the cycle even though this could lead to an inability to meet demands for credit in a downturn.Source: Eva Catarineu-Rabell, Patricia Jackson and Dimitrios P Tsomocos in “Procyclicality and the new Basel Accord–banks’ choice of loan rating system“

Procyclicality, bank provisions and IAS 39

In addition to the minimum capital requirements, the role of bank provision is important. Turner argues that the ideal response to procyclicality is for banks to make adequate provisions for possible loan losses. Often however, he says, tax laws limits the tax deductibility of precautionary provisioning because loan loss provisions increase internal funding for the bank only to the extent that they reduce taxes. Furthermore, securities authorities like the SEC have argued that precautionary provisioning distorts financial reports and may mislead investors. The building up of provisions may conflict with the demand for well-document accounting. Philipp Turner in “Procyclicality of Regulatory Ratios?“

More specificially, the introduction of International Accounting Standard 39 requiring fair-value accounting make bank provisions more pro-cyclical, as José Viñals discusses:

IAS39 adds to procyclicality in the financial system through the introduction of fair-value accounting. [...] There is also a serious risk that, if the new rules are interpreted too rigidly, they could discourage, complicate and even prevent the implementation of some solutions to the procyclicality problem such as forward-looking provisioning.

Consequently, IAS39 might not only exacerbate procyclicality but also make it more difficult for regulatory policy to deal with procyclicality. In particular, Basel II is mainly about capital (to cover unexpected losses) and thus does not deal in depth with provisions (e.g. to cover expected losses, as in the case of forward-looking provisions). In turn, IAS39 contemplates only ‘incurred losses’ as far as provisions are concerned. Hence, under a rigid interpretation, IAS39 would not be compatible with a system of forward-looking provisions.

Solutions for Pro-Cyclicality

The problem of pro-cyclicality reflects a deeper problem of financial regulation. On the one hand, financial regulation for banks under Basel II was made more sensitive to the business cycle by relying on external credit assessment (in pillar 1 of Basel II) and fair-value-accounting (in pillar 3 of Basel II). The motivation behind these changes was to move away from the often arbitrary risk-weights assigned in Basel I. However, with more risk sensitivity of financial regulation, banks amplify the business cycles and contribute to systemic risk. In other word, the methods to avoid systemic risk are contributing to increase systemic risk.

There are a handful of proposals to change various aspects of Basel II. George G. Pennacchi, for example, suggests moving to a risk-based deposit insurance system which encourages less procyclicality of bank loans then risk-based capital ratios. In a policy brief from the FSA, the authors discuss between adjusting “Pillar 1″ or “Pillar 2″ approach to counter procyclicality. “Pillar 1″-approach would be the modification of rating methodologies for capital requirements, “Pillar 2″-approach would mean relying increasingly on procyclicality stress tests to increase, if necessary, regulatory capital. The authors argue that the “Pillar 2″-approach is politically more feasible while the “Pillar 1″-approach would make more sense.

Several authors call for a more comprehensive approach to tackle the problem. In a speech given by William R White, Economic Adviser and Head of Monetary and Economic Department of the Bank for International Settlements, advocates a “new macrofinancial stability framework” which encourages regulators and central banks to resist the pro-cyclicality of the financial system.

Such a system would pay attention to the impact of systemic shocks, a close cooperation between central bankers and regulators in assessing the build-up of systemic risks, and a countercyclical use of policy instruments. Monetary policy and regulation would push in the same direction: credit tightening in times of growth and credit expansion in recession would go together with a biased regulatory policy of risk spreads (for expected losses), provisioning (for subsequent changes in expected losses), and capital (for unexpected losses) being increased in good times and decreased in bad times. He proposes to alter the capital required for credit risk with a formula based on estimates of system-wide increases in exposure. The formula could make use of the rate of growth of aggregate credit and asset prices from longer-term trends.

White advocates a international agreement for such a framework and improving risk management procedures under Basel II. The biggest impediment against moving towards such an international agreement, assuming consensus on the causes of the crisis and availability of the appropriate tools, is the act to will. Policy makers face the bureaucratic inertia and vigorous lobbying (against reacting) from the many people being made rich by the crisis. Central bankers face the problem that counter-cyclical regulation and tightened credit could strangulate an economy more than necessary. Regulators face the problem of not having long cultural tradition of concern for macroprudential issues and not seeing the big-picture of macro-financial stability. White suggests to include an automatic response to the procyclical tendencies of the financial system. (See also Whites paper “Procyclicality in the financial system: do we need a new macrofinancial stabilisation framework?” and the similar suggestions by Claudio Borio, Craig Furfine and Philip Lowe).

Conclusion

Business cycles are a necessary characteristic of an open economy. The fact that the financial systems moves along with the business cycle is a necessesary consequence of the fact that the actions of the financial system reflect the underlying changes in the real economy.

Regulators, central banks and policy-makers have a natural tendency to dampen the business cycle: through the use of fiscal, monetary and regulatory policy. To some extent it is however not possible to get rid of both things at the same time: financial instability and pro-cyclicality.

Financial stability rests on using the information about the state of risk provided by the market, but at the same time pro-cyclicality is increased by relying to heavily on the market for providing information about risk. Pro-cyclicality and financial stability are two sides of the same coin.

They distinguish several types of risk:

• expected and unexpected losses (in the statistical sense)
  1. “Expected losses” refer to the average or mean losses anticipated over a particular period
  2. “Unexpected losses” refer to a measure of the dispersion, or degree of uncertainty that surrounds that outcome
• relative and absolute risk
  1. Relative risk relates to the risk, in a cross section, of a particular financial instrument, portfolio or institution (“Bond A is riskier than Bond B”)
  2. Absolute risk relates to the specific value that the measure of risk takes at a particular point in time (“Portfolio X is more risky today than it was last year”)
• idiosyncratic and systematic risk
• Systematic risk is associated with the correlation between components of a financial system arising from exposures to common factors, such as specific industries or the business cycle.
• risk of individual portfolios and risk of the financial system as a whole.

According to the authors, measuring risk is difficult because it entails

• assessing the riskiness of each individual borrower
• assessing how the correlations between borrowers are changing
• assessing how the institutions collectively affect the health of the economy
• assessing how the health of the economy affects the collective health of individual institutions.

The authors also claim that systemic risk is often related to a common exogenous shock resulting from a change in the business/financial cycle:

Widespread financial system stress rarely arises from the contagion or domino effects associated with the failure of an individual institution owing to purely institution-specific factors. More often, financial system problems have their roots in financial institutions underestimating their exposure to a common factor, most notably the financial/business cycle in the economy as a whole.

Risk measurement in banks often falsely assesses the development of risk:

Many of the risk measurement methodologies used by banks, rating agencies and bank supervisors imply that risk falls during booms and periods of financial market stability and increases only during recessions and periods of financial turmoil. But it is better to think of risk as increasing in booms, not recessions, and that the increase in defaults in recessions simply reflects the materialisation of risk built up in the boom.

The business-cycle has an impact on the emergence of systemic risk, at least in the long-run:

Despite recent research suggesting that a number of financial variables are useful in predicting recessions, macroeconomic forecasters have a poor record in predicting the exact timing of recessions or turning points in the business cycle. Being able to predict the exact timing of a downturn is by no means necessary to design an appropriate response to it. Using longer horizons would help  lessen some of the emphasis on short-term forecasting, and promote a more thorough analysis of financial vulnerabilities associated with business and financial cycles. This would promote better assessments of systematic risk.

The set of factors that can result in either misperceptions of risk are:

• Use of the “wrong” model of the economy to interpret developments
• Disaster myopia = tendency to underestimate the likelihood of high-loss low-probability
• Cognitive dissonance = tendency to interpret information in a biased way, so that it reinforces the prevailing belief entertained by the economic agent.23

The set of factors that can result in inappropriate responses to risk are:

• failure to internalise the consequences of the actions of others
• the impossibility of coordinating responses
• costs borne by other groups in society
• “herding behaviour” = agents conform their behaviour to that of their peers
• shortcomings in contractualarrangements stressing short-term performance

In this post, the main recommendations are going to be listed and assesses whether they have been implemented.

IMF

• The IMF should serve as quasi lender of last resort (LOLR) to emerging economies.

  The IMF is acting less and less as LOLR to emerging economies. Most loans to emerging economies hit by the Asian or the Russian crisis have been paid back (see paper by William Cline). To become LOLR, the IMF would need more funds and more access to supervision, as Olivier Jeanne and Charles Wyplosz argue in this IMF paper.

• Eligible member countries must permit freedom of entry and operation for foreign financial institutions.

  Financial integration of emerging economies has increased to some extent – mostly in Europe, leastly in Latin-America and Asia in the middle (see BIS-Paper by Alicia García-Herrero and Philip Wooldridge. The main integration was regional rather than global.

• Every country that borrows from the IMF must publish, regularly and in a timely manner, the maturity structure of its outstanding sovereign and guaranteed debt and off-balance sheet liabilities.

  Measuring public debt is not an easy taks because of the different types and issuers of public debt. The BIS, the World Bank, the IMF and the OECD maintain the Joint External Debt Hub which collects and publishes information about sovereign debt. A list of central government debt for 89 countries between 1991-2005 is available at the Inter-American Development Bank.

• Commercial banks must be adequately capitalized either by a significant equity position, in accord with international standards, or by subordinated debt held by non-governmental and unaffiliated entities.

  Standards for minimum capital for banks and other financial institutions are given by Basel II, but the final decision on how to implement Basel II was not reached until July 2007.

• The IMF in cooperation with the BIS should promulgate new standards to ensure adequate management of liquidity by commercial banks and other financial institutions so as to reduce the frequency of crises due to the sudden withdrawal of short-term credit.

  The adequate bodies would not be the IMF and the BIS, but the BCBS and other international bodies such as IOSCO or IAIS.

• The IMF should establish a proper fiscal requirement to assure that IMF resources would not be used to sustain irresponsible budget policies.

  The IMF has introduced and updated several codes for fiscal transparency.

• The IMF should use its policy consultations to recommend either firmly fixed rates (currency board, dollarization) or fluctuating rates.

  Just like in 2001, the world is still far away from completely floating exchange rates for all currencies (see IMF overview of Exchange Rate Arrangements in 2006).

• The IMF should cease lending to countries for long-term development assistance (as in sub-Saharan Africa) and for long-term structural transformation (as in the post-Communist transition economies). The Enhanced Structural Adjustment Facility and its successor, the Poverty Reduction and Growth Facility, should be eliminated.

  The Poverty Reducation and Growth Facility is still active. Togo has been the most recent recipient in April 2008.

• The IMF should write-off in entirety its claims against all heavily indebted poor countries (HIPCs) that implement an effective economic development strategy in conjunction with the World Bank and the regional development institutions.

  Through co-operation of creditors in the Paris Club and together with IMF and World Bank, several debt relief initiatives for heavily indebted poor countries have been implemented. The IMF estimates that about 40% of debt has been cancelled.

• Further quota increases for the IMF are not necessary.

  Adjusting quota shares is necessary to reflect the economic development of various IMF Members. Often this was done by increasing quota for some countries. If the USA wants to keep its defacto veto of having more than 15% of votes, then it also needs to increase its quota.

  The Development Banks

• The development banks must be transformed from capital-intensive lenders to sources of technical assistance, providers of regional and global public goods, and facilitators of an increased flow of private sector resources to the emerging countries.

  The World Bank has programs for technical assistance and co-operation with the private sector through the International Finance Corporation.

• The focus of their individual financial efforts should be on the 80 to 90 poorest countries of the world that lack capital market access.

  This would not only be counterproductive, because the World Bank provides technical assistance along with financial help, but it would also set the wrong incentives because countries with difficult capital market access would then stop their efforts to achieve that goal.

• All resource transfers to countries that enjoy capital market access (as denoted by an investment grade international bond rating) or with a per capita income in excess of $4000, would be phased out over the next 5 years.

  Poverty and a good bond rating are not mutually exclusive. Often countries might still be in financial need even though their treasury bonds might have excellent ratings. This proposal contradicts with the previous one, because some countries have access to bond markets but their per capita income is well below US-$ 4000.

• In poor countries without capital market access, poverty alleviation grants to subsidize user fees should be paid directly to the supplier upon independently verified delivery of service. Costs would be divided between recipient countries and the development agency. The subsidy would vary between 10% and 90%, depending upon capital market access and per capita income.

  The World Bank is more and more engaging with the private sector and funds directly the supplier. Often however governments supply certain goods and then financial support from the World Bank becomes an indirect transfer of funds to goverments.

• The government of each developing economy would present its own reform program for institutional change which would be supported by the World Bank and audited independently.

  Institutional change needs to go along with changes in social and political norms. The problem is not drafting a reform agenda, but implementing them and creating the mechanisms for a continuous evolution.

• To underscore the shift in emphasis from lending to development, the name of the World Bank would be changed to World Development Agency. Similar changes should be made at the regional development banks.

  A name change has not occured and would most likely be strongly contested by United Nations institutions reponsible for development.

• All country and regional programs in Latin America and Asia should be the primary responsibility of the area’s regional bank.The World Bank should become the principal source of aid for the African continent until the African Development Bank is ready to take full responsibility. The World Bank would also be the development agency responsible for the few remaining poor countries in Europe and the Middle East.

  There is still considerable overlap between the various regional development banks.

• The World Bank and the regional development banks should write off in entirety their claims against all heavily indebted poor countries (HIPCs) that implement an effective economic development strategy under the Banks’ combined supervision.

  See above to a comment on the similar IMF reform proposal.

• The United States should be prepared to increase significantly its budgetary support for the poorest countries if they pursue effective programs of economic development.

  Even though the USA is the largest donor of development aid, compared to its economic power it only donates a marginal amount to development (about 0.17% of GNI)

The Bank for International Settlements

• The Commission recommends that the BIS remain a financial standard setter.

  The main standard-setting bodies are the BCBS, the IOSCO, the IASB, the IAIS and the FATF. All cooperate with the BIS, but are not the same.

• Implementation of standards, and decisions to adopt them, should be left to domestic regulators or legislatures.

  Especially in Europe, the Commission was a driver of implementation of already negotiated standards, thus it is not always clear whether national discretion to implement at will is the best way to establish international standards.

• The Basel Committee on Bank Supervision should align its risk measures more closely with credit and market risk.

  Basel II is the attempt to do exactly that.

The World Trade Organization

• Rulings or decisions by the WTO, or any other multilateral entity, that extend the scope of explicit commitments under treaties or international agreements must remain subject to explicit legislative enactment by the U.S. Congress and, elsewhere, by the national legislative authority.

  WTO Agreements have to be ratified and implemented in national legislation, but non-compliance can be countered by sanctions and other enforcement mechanism. Whether the Dispute Settlement Mechanisms at the WTO undermine national sovereignty or create a fair playing field for all countries under international trade law is a different matter.

• AIBD – Association of International Bond Dealers, now ICMA.
• BIS – Bank for International Settlements
• EBR – European Bank for Reconstruction and Development
• ECB – European Central Bank
• EIB – European Investment Bank
• ECSDA – European Central Securities Depositories Association
• IASB – International Accounting Standards Board
• IASC – International Accounting Standards Committee
• ICMA – International Capital Market Association
• IMF – International Monetary Fund
• ISSA – International Securities Services Association

More can be found here

The global financial architecture is very complex. Despite increasing liberalization of financial markets, increased system risk and integration of the economies through the financial markets in the last 30 years, there is no single World Financial Authority regulating the financial markets, as Alexander, Eatwell and Dhumale have suggested.

Instead what we have is a complicated system of co-ordination between regulators, intergovernmental co-operation and private standard-setting bodies creating “soft law” which then is adopted into legislation on the national and in case of the European Union on the transnational level.

Strangely enough, there is no single member-driven rule-based regime like in the fields of trade with the various trade rounds or environment with the Kyoto protocol, and no single dispute settlement emerged like the Dispute Settlement Body at the World Trade Organisation.

The Weak IMF, the strong BCBS

Even more puzzling is the fact that after the end of the Bretton-Woods-Regime of fixed exchange rates, the IMF did not develop into the center for political co-operation on financial matters as envisioned by the founders of the Bretton-Woods-Institution.

The joint expertise of the World Bank (which is really a development fund) and the IMF (which is really a bank for sovereign debt) would have made it an ideal combination to govern the worlds financial markets.

It is important to remember that Harry Dexter White, who negotiated on behalf of the US at Bretton Woods, wanted to abolish the Bank of Central Banks (the BIS in Basel) and give more power to the IMF to conduct monetary matters, but he never succeeded.

Not only did the IMF never fulfill its role as envisioned by Keynes and White, but after the end of the Bretton-Woods other key players re-surfaced in the turmoiled waters of financial regulation.

The Basel-System centered around the Bank for International Settlements gave birth to a transformed committee working on what turned out the most relevant dimension of global financial governance: banking supervision. The standards set by the BCBS have shaped the financial architecture more than any other standards set by the IMF or the OECD.

Evolution in Waves

Together with the BCBS, a plethora of private and public bodies emerged since the 1970ies. The evolution of this system was crisis driven, with the G7 Finance Ministers and the G10 Central Bank Governors setting the agenda.

From the middle of the 1970s onwards, several international organizations were founded and specialised in their respective part of the financial markets. The second half of the 1980s sees a further specialisation and the founding of specific task groups, like the Financial Action Task Force on Money Laundering.

The second half of the 1990s sees attempts to coordinate the various bodies more efficiently and approach problems such as threats to global financial stability. Since the turn of the millenium, the founding of several European bodies reflects the increased integration of the European Financial Markets.

There is no clear trend that financial regulation moves strictly in one way from the national to the international level. There is also no clear trend that national regulation moves from the strict functional approach of having supervisory agencies for the different type of actors in financial markets (banks, securities firms, insurers) to unified supervisory structure, although at least in some countries of the large G8 countries (UK, Germany, Japan) unified supervisory agencies have emerged (in countries like France, Italy and the US discussions about unifying the supervisory structures have started).

Explanations for the absence of institutionalism in financial governance

Financial governance consists of various dimensions:

1. Establishing a framework for the functioning of financial markets (for instance by establishing clearing and payment settlement systems).
2. Regulate, supervise and enforce regulation on market participants.
3. Improve competiveness of the financial markets by allowing new types of financial products.
4. Encourage market transparency and availability of information about markets.
5. React to financial crises, for instance with a Central Banks as a lender-of-last-ressort-function.
6. Restructure financial regulation to achieve financial stability, avoid contagion and reduce systemic risk.
7. Manage international macro-economic conditions through the intervention in exchange rate markets, managing national macro-economic through monetary and fiscal policy.
8. Discourage criminal activity in the financial markets, such as fraud, money laundering, financing of illegal activies (drugs and terrorism).

There are some explanations for this complex financial architecture with multiple power centers and various levels:

• The different aims of financial governance compete and sometimes contradict with each other. For instance macro-economic exchange rate management competes with the aim of financial stability if exchange-rate management needs to a currency crisis. Thus it is more rational to spread the various dimensions of financial governance to various bodies.
• The required level for market- or government-knowledge is very different for each of the dimension. For instance standard-setting and supervision needs a lot of technical information about the markets, therefore the BIS and Central Banks have a clear advantage because they operate in the markets. For other functions, for instance managing sovereign debt it is more important to have access to administrations and governments, therefore the IMF is better suited for that task.
• The different centers of financial governance reflect that financial architecture is not neutral, but it protects or damages interests of certain parts of the financial industry. For instance, the Basel-System can be seen in opposition to the Washington-based institutions reflecting different preferences of Europeans vs. Americans.
• Communication and coordination methods have changed how intergovernmental co-operation is conducted. An institution like the IMF would maybe look very different if founded today, but path-dependence restricts reform of institutions drastically.

A Research Outline

These explanations however offer only superficial insight into the dynamics of the financial architecture. Research on this topic will most likely have the following structure:

1. Defining Financial Governance
   • comparing several theoretical approaches from Political Economy and Political Science
   • outlining the difference between governance and government
   • outlining the difference between institutionalism and intergovernmentalism
2. Describing the Financial Architecture
   • Mapping the Financial Architecture
   • Describing the different power centers of financial governance
   • Describing the role of different organisations
   • Outlining co-operation mechanisms
   • Explaining the evolution of the current financial architecture
   • Discussing the various types of intergovermentalism in the current financial architecture
3. Case Studys
   • Banking Supervision
   • Money Laundering
   • Domestic Bonds
   • Hedge Fund Regulation
   • Currency Crises
   • Liquidity Crises
4. Proposals for Reform

How the global financial architecture evolved and how that influences the probability of crisis is very rarely discussed. In the analysis, the network structures of the global financial architecture is often forgotten.

The financial architecture is the system of public and private bodies which try to influence the regulation and standards required for financial markets to function. These are the the main types of actors in the financial architecture:

• Governments
  1. National governments, in particular finace ministers
  2. Informal meetings of government officials, such as the G7
  3. Supra-national government organisations, such as the EC
  4. International organisations representing the interests of governments, such as the IFM, World Bank, OECD.
• Central banks
  1. National Central Banks
  2. Informal Meeting of Central Bank Governors, such as the G10
  3. Supra-National Central Banks, like the ECB
  4. International Organisations of Central Banks, such as the BIS
• Regulators
  1. National Regulators responsible for
     • Banks and other financial intermediaries
     • Securities Firms and other type of trade of financial derivatives
     • Insurers
  2. Supra-National Meetings of Regulators
     1. with specific regulatory tasks, such as CEBS, CESR or CEIOPS
     2. with over-arching regulatory tasks
  3. International Meetings of Regulators
     1. with specific regulatory tasks, such as BCBS or IOSCO
     2. with over-arching regulatory tasks
• Private Bodies
  1. National Lobbying Group of Financial Institutions
  2. Surpa-National Lobbying Group of Financial Institutions
  3. International Lobbying Group of Financial Institutions
• Academic Consultancies and Think Tanks
• NGOs

The heuristics still has some weakness, but it helps to get a first picture of the financial architecture.

It is difficult to get a meaningful categorization of the private bodies because scope and membership of these private bodies are overlapping. Some of these organizations have identical aims but conflicting interests because they represent financial actors from different regional constituencies without however saying this in their statutes.

The categorization concerning NGOs and Academic Institutions lacks details because they are not the main actors in standard-setting, which is the second part of the financial architecture. So in addition to the actors, a list of standards would be needed which then can be attributed to particular organisations.

There are quite a few hybrid bodies and it is difficult to put them into the system above, such as the FSF. Also the disction between public and private organisations are not as sharps, because many public bodies have advisory councils consisting of representatives from banks or other large financial institutions.

The distinction between regulation, standards and lobbying is also quite blurred. In financial markets, self-regulation and technical standards agreed upon without government intervention play an important role. Regulation sometimes reflects either the attempts of the industry to self-regulate (for instance in Codes of Conduct) or serves the interests of certain part of the industry to keep their competitors out of certain market segments.

The Mapping-Project undertaken here aims to get a better understanding on how standards are produced, how the financial actors communicate and co-operate and how the financial architecture is being build.

Key Questions to be asked will be:

• Decision-Making Process
• Established by law or statute

The G-7 meetings are ‘potentially’ the most important in the world. This is the gathering of Finance/Treasury Ministers and Central Bankers of historically the seven most economically powerful nations.

There is a big gap, however, between potential and reality when it comes to fixing the problems in financial systems. Central bankers will not permit it.

[...]

With people who run the Bank of Italy, the Bank of Canada and the US Treasury today having close ties to Goldman Sachs, there is not a snowball’s chance in Bahamas that the endemic conflict of interest issue in financial services, which is the heart and soul of the problem, will ever be addressed.

So the pabulum fed to the public from the G-7 is an insult to our intelligence. Unless and until these most powerful governments take control of their treasuries from central bankers, their capital markets will continue to sink into an abyss where bankers will suck dry the wealth and the dreams of the People until they rebel.

Unfortunately, he does not go more into the argument of the diverging interests between Central Bankers and Finance Ministers. Finance Ministers in the history of the G7 have always tried to bring the Central Banks at the same table, and with the Financial Stability Forum even the regulators sit at that table.

There are two explanations for that:

1. Finance Ministers don’t understand the often technical questions related to financial regulation.
2. Finance Ministers don’t want to be involved in the sometimes uncomfortable dealings of monetary policy and need ’scapegoats’ to blame for unpopular decisions like deflation.

The truth, as always, is in the middle. Most finance ministers know quite well the technical and legal details of financial regulation, although there are exceptions. Nevertheless, supervisory agencies and central banks often have a more direct access to markets than the political bodies, thus they are more informed and maybe more sensitive to what is happening in the markets. That is why the Bank for International Settlements as Bank for Central Banks still plays such an important role in the Financial Architecture .

Good financial regulation needs to have an ear at the market, otherwise it will be ignored by market participants. The conflict of interest is not really between finance ministers and central bankers, but between good intentions and bad outcomes.

Bill Cara has a point though, as Central Banks are often more inclined to listen to large commercial banks than to other participants in the markets. Would the US Fed bail out a monoline insurer? Maybe not, but certainly an investment bank.

In addition to that, it is quite convenient for Finance Ministers not to be responsible for Monetary Policy or Financial Regulation. It allows some rather uncomfortable decisions to be made by “neutral” bodies.