It certainly makes sense to involve private bodies and the representatives of business when creating standards. The technical expertise of these bodies is valuable for ensuring that the goals of the regulation are feasible and achievable.

However, standards are not neutral, they not only provide a public good of a market framework which lowers transaction costs and deters fraudulent behaviour, they also serve those who are setting the standards. One interest of a private body could be to exclude competitors from gaining market share by obligating standards which these competitors can’t fulfill.

In the debate on the causes of the sub-prime crisis, media and academia are discussiong the incentives set by standards. They claim that Basel II has encouraged pro-cyclicality of Bank lending, or that reliance on Credit Rating Agencies in regulation has reduced the banks effort to conduct their own diligent risk management. The overall criticism is levered at governments, central banks and regulators for setting up the wrong system of financial regulation.

Attached to this criticism is the challenge that the current system of co-ordinating financial regulation is not working. Calls for a World Financial Architecture (see book by John Eatwell and others) are being heard.

However, it is often ignored that for standards to be functional, the private sector needs to be a consistent advocator of good standards. This should be reflected in a financial architecture which involves the private sectors in the crucial decisions on standard-setting, impact assessment, implementation and enforcement. Such an involvement is only possible if the private sector can give a coherent response to the demand for consultation coming from the public sector.

What is most striking is that the private sector does not speak with one voice. With ICMA, SIFMA and the IIF there are three private institutions speaking on behalf of the capital market. The G30, as a quasi corporative think-tank, ammends these views on serves as a coordinating body between highly influential individuals in the international financial institutions.

It would be interesting to have a closer look at this network of institutions and individuals:

• Which companies are members of which institution?
• Which individuals are members of which institution?
• Which companies and which individuals are key nodes in this network?
• Is there an overlap of tasks of the private institutions?
• Which formal and informal coordination groups exist between the bodies representing the views of the financial actors?

Would financial institutions disclose this kind of information?

At the beginning of their article, they point to the fundamental trilemma of financial supervision. They sait that only two out of these three incompatible objectives can be achieved:

1. Stable financial system.
2. Integrated financial market.
3. Independent national financial supervision.

The authors also define contagion as shocks which propagate from one financial institution to the other by two channels (p. 266):

• Exposure channel: domino effects resulting from real exposures in the interbank markets and/or in payment systems.
• Information channel: contagious withdrawals (bank run) when depositors are imperfectly informed about the type of shocks hitting banks and about their physical exposure to each other (asymmetric information)

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 existence of risk is a necessary feature of markets. The existence of systemic risk is a necessary feature of highly integrated markets. Both on the national and the international level, there is always the potential for a system-wide collapse of markets because a large number of market participants reassess their risk profiles and act accordingly, for instance by disinvesting from certain asset classes which then leads to decreased liquidity in some parts of the markets.

Market participants should be aware of the existence of systemic risk and price in in their investor decisions. There are several reasons why this is difficult:

• Firstly, it is not easy to locate the first domino-stone which brings a market to a collapse, even if all market participants agree that a collapse is immanent.
• Secondly, it is not easy to price the effects of market collapse on individual asset classes.
• Thirdly, it is very difficult to predict the political economy of market collapses and the bail-out attempts by policy-makers.

Given these difficulties, there is considerable possiblity that market attempts fail to correctly price systemic risk, even if their intentions are well. Also, given these difficulties, it is quite likely that regulators will not necessarily ex-ante be able to predict the right measures to avoid systemic risk.

Another issue needs to be kept in mind: financial products with the highest yields are at the edge of financial regulation. Financial institutions are most competitive where regulation is contradictory, available for regulatory arbitrage or simply not spelled out yet. Therefore most market participants, especially banks, do not mind that systemic risk exists. Systemic risk allows them to make a business.

In essence: systemic risk is not a negative externality that needs to be re-internalized through regulation, as Kern, Eatwell and Dhumale suggest. Systemic risk should be seen as the break up of network-communication inside a system and regulation needs to ensure that communication channels are promptly restored after a market collapse.