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

The April 11 statement was “not very different” from the importance of the 1985 Plaza Accord.

The Plaza Accord reached by the G7 in 1985 refers to a joint intervention in the Currency Markets against the stark appreciation of the US-Dollar in the 1980s. If the comparison is right, then Finance Ministers and Central Bank Governors have agreed to intervene into the currency markets to stabilize the value of the dollar.

Log nominal value of US dollar against other major currencies. NBER defined recession dates shaded gray. Source: Federal Reserve Board via FRED II via Econonbrowser.

Menzie Chinn at Econbrowser discusses the article and is skeptic about the capability of G7 finance ministers to intervene in foreign exchange markets:

• Policymakers, especially finance ministers, have limited means to affect exchange rates directly. [...]
• The evidence that sterilized intervention works is actually more mixed than is commonly allowed. [...]
• When effects of intervention have been identified, they typically (although not always) seem to be of a short term nature. [...]

Prof. Chinn goes on to quote from Owen Humpage’s “Government Intervention in the Foreign Exchange Market” (2003):

Sterilized intervention affords monetary policy makers a means of occasionally pushing an exchange rate in a desired direction. The alternative level then serves as a new starting point for a random walk process compatible with existing fundamentals.

Prof. Chinn then argues that while monetary policy makers cannot change the underlying market fundamentals, their signal to intervene in currency markets can be credible if also the fiscal policies are adjusted.

He predicts that the exchange rate intervention is not immiment, but will occur sooner or later:

If the Fed perceives that the dollar has dropped far enough to keep the U.S. economy out of a deep recession, and the ECB perceives the euro has risen enough to adversely impact euro area economic activity at a time of a pronounced slowdown (see here), then “the stars will be aligned” for a change in the path of (monetary) fundamentals, and hence the value of the dollar.

It is strange that both the Bloomington article and the Econbrowser-blog-post focus so much on exchange rates because Christine Lagard does make some interesting comments in the interview given to Bloomberg Television.

She points out to a special calendar: a 100-day-action-plan (with one of the instruments being a call for disclosure of the losses by banks) and a 300-day-action plan. The measures suggested in the FSF-Report are however not as clearly structured in a 100- and 300-days-action-plan.

Interestingly as well, she sees the changes of International Accounting Standards to be the most crucial one:

Bloomington: Is there a specific change, a specific part of that plan that will make the most immediate difference?

Lagarde: I think the demand that we are putting on the International Accounting Supervisory Board [probably the IASB] is going to be the most critical one. Because what we are saying is actually that the accounting principles that apply at the moment – the marked-to-market is fine, we are not questioning that at all – but we’re simply saying that in the absence of market [liquidity] then clearly additional tools need to be used, indices and various other mechanisms that we want the IASB to actually recommend. And that is important because it will help banks in particular, financial institutions in general, to actually to put a value on something which could not be valued so far.

To make another prediction: the micro-economic changes agreed upon by the G7 Finance Ministers will have a much bigger impact on this crisis as the exchange interventions that the interested public mind seems to crave for.

To assess the impact of the report on the global financial architecture and the responses to the credit crisis in the financial markets, it is worthwhile recalling the original demands of the G7.

In essence, the FSF was asked to look at the underlying causes of the credit crisis (which it did) and make proposals for tackling the problem. Quite clearly the FSF concentrated mostly on the micro-economic implications of Financial Regulation and not so much on more macro-economic developments, such as global interest rates, exchange rate movements or the role of new actors like Sovereign Wealth Funds as (de-)stabilizing force in the Financial Markets.

The general message of the report cam be summarized as follows: Blame the banks, blame the credit rating agencies, blame national supervisors! There is very little blame directed at the political level, the central banks or the international bodies coordinating supervision.

This however was expected, given that G7 wanted the conduct of business by the banks (especially the business of off-balance-sheets-vehicles which speculate heavily in structured products) and the credit rating agencies (which are involved in analysing and rating structured products, but also in giving advice on how to set-up structured products) to be at the heart of the global regulatory response.

The FSF reponse shows a tricky balance when it comes to the global framework for Banking Regulation. On the one hand, the FSF wants to increase the scope of Basel II and encourage more countries to adopt the framework, on the other hand Basel II has some deficiencies which have worsened this crisis, that a reform Basel II will undergo a scrutinous review.

The report addresses the fields where Basel-II will undergo a review:

• Increased minimum capital requirements for capital requirements for complex structured credit products (such as Colleratlized Debt Obligations of asset-backed securities) when they are in the balance sheets of financial institutions, especially taking into account liquidity risk when the secondary market for these products evaporates.
• Increased minimum capital requirements for the so-called off-balance-sheets vehicles.
• Less reliance on the ratings of credit-rating agencies when assessing the liquidity risks of securities and less reliance on the ratings of monoline-insurers in Basel II.

The main task of reforming Basel-II will reside in the BCBS, but it seems that other organisations such as IOSCO and IAIS will provide guidance. Furthermore, the FSF will provide guidance for the national regulators to improve their supervision and enforcement of the Basel-II-rules and ensuring that the financial institutions have adequate risks management models.

The enforcement of the national supervisors is also crucial when disclosing losses, which the FSF has enphasized in quite drastic words. The FSF has put out the mid-year reports as a condition for the banks to disclose their losses for two reasons:

• firstly, it wants to overcome the prisoner-dilemma of banks which are faced with the problem that a joint disclosure of losses in the long-term leads to increased trust in the interbank-lending-markets, but in the short-run represents a punishment by the markets when share prices drop.
• secondly, disclosing the losses will be a precondition for a bail-out through lower interest rates by the central banks which the financial institutions could use to recapitalize themselves.

Interestingly, also the IAASB is called upon for to improve the auditing standards, despite the fact that at least in the public mind, incorrect auditing was not the big problem of the credit crisis. The IASB is also called upon to update International Accounting Standards, especially for structured products. Finally, markets are urged to implement better settlement standards for OTC-derivates. All three events point to the problem that underlying causes of the credit crisis is really market information.

The heavy attack on the Credit Rating Agencies follows the market information perspective, but seems to be politically motivated. The internal code of conduct of Credit Rating Agencies does minimize conflict of interests and the IOSCO-2004-Code for CRAs (which is called for an update by 2009) is too vague and general as to really provide some substantial guidance.

Most likely there will be regulation calling for internal firewalls between the departments dealing with the consultancy for structured products, and the analysts rating structured products. As the FSF indicates, there will also be regulation that the CRAs have to introduce differentiated rating schemes for structured products.

Yet it is not clear that all of these measures will help to tackle the fundamental problem of the global financial market, which is an often incoherent and overlapping financial architecture regulating financial markets.

For large financial conglomerates, the regulatory landscape is very complex. The FSF proposes to introduce “Colleges of Supervisors” from the main jurisdictions. This is an interesting idea, especially because such “Colleges of Supervisors” are also going to be introduced for Cross-Border Financial Institutions.

It is also to be welcomned that the international bodies are encouraged to develop more closer cooperation, especially the IMF and the FSF are moving closer again. Whether this is motivated by the idea of strengthening the role of the IMF or linking macro-ecnomic and micro-economic aspects of Financial Stability, can only be speculated.

In any case, there is no central, singular, international, supervisory authority and given the complexity of the problem, it is unlikely that such an authority will emerge any time soon. But until then, the reform of the financial architecture will be patchwork – and the FSF Report is a good example of this principle.

The Chicago Board of Trade set up the Chicago Board Options Exchange in 1973, the American Stock Exchange and the Philadelphia Stock Exchange began trading stock options in 1975, the Pacific Exchange in 1976.

Mental note: find out when other Stock Exchanges (in the other G7 countries) opened their options markets and see if that relates to the profound changes in the markets going on after the end of fixed exchange rates (and if so why exchange rate regimes suddenly have an impact on the organization of stock markets).