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.

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.

In summary, Banks take the blame for the credit crisis by saying that lending standards declined, securities were not sufficiently underwritten, structured products not fully understood, liquidity risks (when markets dry out) not anticipated and because of poor management reputational risk (which result in the stock prices of bank going down) not foreseen for the banks.

The IIF suggests a code of conduct for the major financial institution. The motivation is twofold: such a code of conduct should send a signal to the regulators that the financial industry does not need new regulation. It is questionable though, whether regulators continue to rely on voluntary standards, such as the IOSCO Code of Conduct (2004) for Credit Rating Agencies or the Hedge Fund Code of Conducts (2007).

The second motivation is toward the markets: a code of conduct can be a signal to the markets that certain risks are being addressed. However, markets are more difficult to fool than regulators: if a code of conduct is simply a piece of paper which does not reflect the practices of financial institutions, then markets won’t take the bait.

One weakness of the proposal by the IIF is already included in the proposal: because of the diversity, there will be no single standard for the whole industry. The report says:

Because there are substantial differences in business models, mix of business, exposures,
regulatory oversight and culture, there is unlikely to be a single solution to any issue that would be optimal for all firms and all circumstances. Thus, “best practice” as used here is not a legal obligation but a high standard for firms to apply in developing solutions appropriate to their own situations.

The IIF report calls for improved standards in areas: risk-management governance; technical risk-management issues; and stress testing. They admit that questions have been raised about…

…the ability of certain Boards properly to oversee senior managements and to understand and monitor the business itself.

The report wants to establish a “risk culture” and “three lines of defense” (business management, risk management, audit and control functions). The problem however is not so much that the existing regulation did not already establish these mechanism. The problem is that often the management encouraged the taking of excessive risks claiming that their competitors did the same. This “herding” led to the problem of prudent banks such as the German Landesbanken or the IKB speculating heavily with products they did not fully understand.

In essence, it is doubtful if voluntary standards will satisfy the regulators, but the debate between regulators and industry surely has taken an interesting turn.

(Will be continued)

• Institution: International Monetary Fund
• Abbreviation: IMF
• Type: Public
• Founded: 1944
• Members Total: 185
• Membership in: FSF
• Membership of:
• Description: The IMF was established to promote international monetary cooperation, exchange stability, and orderly exchange arrangements; to foster economic growth and high levels of employment; and to provide temporary financial assistance to countries to help ease balance of payments adjustment.
• Working Group:
• Outreach:
• Reporting to:
• Website:www.imf.org
• Highest Organ: Board of Governors
• Chair: Managing Director Dominique Strauss-Kahn
• Seat: Washington
• Function:
• Standards:
Topics of this post: bretton woods, dominique strauss-kahn, finance ministers, financial architecture, imf, Organisations, public, washington
]]> http://www.kasinomics.com/articles/imf/feed/ 3 http://www.kasinomics.com/articles/g24/ http://www.kasinomics.com/articles/g24/#comments Wed, 02 Apr 2008 15:54:09 +0000 kasi http://www.kasinomics.com/?p=32 Continue reading →]]>
• Institution: Intergovernmental Group of Twenty-Four on International Monetary Affairs and Development
• Abbreviation: G24
• Type: Public
• Founded: 1971
• Members Total: 24
• Membership in:
• Membership of:
• Description: The main objective is to concert the position of developing countries on monetary and development finance issues.
• Working Group: Technical Meeting, Deputy Meeting, Minister Meeting
• Outreach:
• Reporting to: G77
• Website:http://www.g24.org
• Highest Organ: Committee of the Whole
• Chair: H.E. Mr. Jean-Claude Masangu Mulongo, Governor of the Central Bank – Congo, DR
• Seat: Washington
• Function:Agenda-Setting for the developing countries
• Standards:
Topics of this post: developing countries, finance ministers, financial architecture, g24, g77, monetary policy, Organisations, public, washington
]]> http://www.kasinomics.com/articles/g24/feed/ 1 http://www.kasinomics.com/articles/g20/ http://www.kasinomics.com/articles/g20/#comments Wed, 02 Apr 2008 15:46:34 +0000 kasi http://www.kasinomics.com/?p=31 Continue reading →]]>
• Institution: Group of 20
• Abbreviation: G20
• Type: Public
• Founded: 2000
• Members Total: 19
• Membership in:
• Membership of: IMF, Worldbank, ECB
• Description: The G-20 is an informal forum that promotes discussion between industrial and emerging-market countries on key issues related to global economic stability. By contributing to the strengthening of the international financial architecture and providing opportunities for dialogue on national policies, international co-operation, and international financial institutions, the G-20 helps to support growth and development across the globe.
• Working Group: not applicable
• Outreach: not applicable
• Reporting to: not applicable
• Website:www.g20.org/G20/
• Highest Organ: General Meeting
• Chair: Brazil
• Seat: not applicable
• Function: Meeting of finance ministers and central bankers from developing and developed countries.
• Standards: not applicable
Topics of this post: central banks, developing countries, ecb, finance ministers, financial architecture, financial stability, g20, g7, g8, imf, Organisations, public, world bank
]]> http://www.kasinomics.com/articles/g20/feed/ 1 http://www.kasinomics.com/articles/g33/ http://www.kasinomics.com/articles/g33/#comments Wed, 02 Apr 2008 15:45:22 +0000 kasi http://www.kasinomics.com/?p=30 Continue reading →]]>
• Institution: Group of 33
• Abbreviation: G33
• Type: Public
• Founded: 1999-2000
• Members Total: 33
• Membership in:
• Membership of: BIS, IMF, OECD, World Bank, Chair of the Interim Committee
• Description: The Group of 33 superseded the Group of 22 in early 1999, and was itself superseded by the Group of 20 later in the year. Several seminars of the Group of 33 on the international financial architecture were convened at the initiative of the finance ministers and central bank governors of the G-7. The first meeting was hosted by Germany in Bonn on March 11, 1999.
• Working Group: not applicable
• Outreach: not applicable
• Reporting to: IMF, World Bank, G7
• Website:www.imf.org/external/np/exr/facts/groups.htm#G33
• Highest Organ:
• Chair: not applicable
• Seat: Washington
• Function: Temporary extension of G7 Finance Ministers Meeting to address mid-term resolutions to Asian Crisis and more broadly issues of Finance and Development
• Standards: not applicable

Sources: IMF Guide to Clubs