I wished I had John Eatwells and Lance Taylors book “Global Finance at Risk: The Case for International Regulation” with me. For anyone interested in important aspects of financial regulations, it is a good starting point. It not only explains how financial markets changed since the introduction of flexible exchange rates, it also makes a good argument on the dilemma that policy-makers face when trying to induce markets to internalize systematic risk. The book also takes apart the notion that a financial crises are always induced by government policies, instead the authors argue that financial cycles leading to a financial crisis can originate in the behaviour of the markets themselves.

Where I disagree with the authors is on their assessment of the necessity of a World Financial Authority. The authors describe the limited capability of domestic regulation in the face of global financial markets and the need to gather the decision-making on the global level. They offer two alternatives for locating the WFA: inside the BIS-System or at an enhanced IMF. The BIS-System has the advantage of market knowledge, access to statistics, and flexibility and thus it would be beneficial to extend the power of this system. However it is unclear whether the USA would agree to move such a lot of regulatory power outside of the US to an institution dominated by Central Banks. And it is not clear whether such a World Financial Authority. And there has been little debate in the current crisis to institutionalize the web of regulatory bodies existing today, probably because any attempt at institutionalization risks loosing the flexibility of the current system.

Benford’s law, also called the first-digit law, states that in lists of numbers from many real-life sources of data, the leading digit is 1 almost one third of the time, and larger numbers occur as the leading digit with less and less frequency as they grow in magnitude, to the point that 9 is the first digit less than one time in twenty. This is based on the observation that real-world measurements are generally distributed logarithmically, thus the logarithm of a set of real-world measurements is generally distributed uniformly.Source: Wikipedia

This characteristic of Benford’s Law can be used to detect fraud, writes Holton. He cites a paper by Nicolas Bollen and Veronika Pool Source: Bollen, Nicolas P.B. and Pool, Veronika Krepely, “Conditional Return Smoothing in the Hedge Fund Industry“. Journal of Financial and Quantitative Analysis.

The authors used statistical analysis to examine the financial reports of Hedge Funds for manipulation. More specifically, they look at reports of Hedge Funds with returns falling close to zero.

Glyn Holton writes:

It indicates the distribution of hedge funds’ returns that happen to fall near zero. The discontinuity Bollen and Pool found is pronounced, and it falls precisely at 0. Wow, isn’t that interesting! Anyone who analyzes data for a living knows there is something profoundly wrong with this distribution. The conclusion is inescapable. Hedge fund managers are inflating their returns to avoid reporting negative returns. The fact that they don’t do so in the months prior to an audit suggests they know what they are doing is wrong.

Holton writes that reports by Hedge Funds can be manipulated in three ways:

• Fraud
• Arbitrary Assumption of Asset Prices in Illiquid Markets
• Cherry-Picking from Brokers reporting higher prices

Pool and Bollen discuss some additional explanations of the statistical discontinuity, but also come to the conclusion that false reporting is the most likely explanation.

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.

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)

He mostly focuses on the role of the Central Bank in the financial system, and in particular about how the Bank of England evolved as bank for the government, a holder of reserves and a lender-of-last-ressort for commercial banks.

Most importantly, he focuses on the informal role of the Bank of England (p.54) and an intermediary between banks and government:

For its part, the goverment relied on the Bank to introduce, monitor and maintain (if not quite enforce) its commands; while the banks and other intermediaries knew that they had to get the Bank on their side inf ay speciial pleadings that they wished to make would be taken seriously by the government. This role provided considerable informal leadership of the City for the Bank.

He also explains that due to that informal role, there were rarely any major banking crises between 1945 and 1973 (p.54):

Banking was an extremely safe, and boring, occupation between 1945 and 1973. There was little credit risk, though there was considerable interest-rate-risk.

The Bank of England rarely had to be active as lender of last-ressort during these years and restricted itself as an arbiter of concerted private sector responses to a crisis.

The change in 1970 and the expansion of credit that came along with it created so-called fringe-banks whose rationale it was to avoid direct controls by the supervisors. These banks often had little capital, highly leveraged, but due to the boom in the property market highly profitable as well.

With the Oil Shock in 1971, high interest rates to combat inflation, the boom ended in a crisis and the collapse of a fringe-bank called “London and County Securities Group” led to a collapse of further fringe-banks. The Bank of England tried to co-ordinate injections of liquidity with the private sector to save some of the salvageable fringe-banks.

What this episode revealed was that there was little, or no, prudential control, or supervision, of the banking, or wider financial, system, and that, in the new competitive, and thereby riskier milieu, such oversight was felt to be necessary, and wouldneed an associated regulatory dimensenion. (p. 57)

The fringe-bank crisis was a British problem, the failure of the Herstatt Bank was an international problem. The Herstatt Bank had speculated heavily in foreign-exchange transactions and in the Eurodollar-Market. The German authorities closed the bank after financial markets closed in Germany, but before the foreign-exchange-markets closed in New York, causing large disruptions there.

The Basel Committee on Banking Regulation and Supervisory Practices was created after the Herstatt Failure and chaired by delegates from the Bank of England until 1988. The Herstatt Failure led to the Basel Concordat which divided responsibility for supervising international banks between host and home authorities. The shutdown of the Banco Ambrosio by the Italian authorities in 1981 even though the Bank was registered in Luxemburg increased the need for co-operation between bank supervisors.

Goodhard explains the shift from liquidity adequacy to capital adequacy (p. 59) in banking supervision:

A bank [...] whose capital [...] had been eroded to a low level would be much more prepared to gamble for resurrection than a better capitalized bank. Also, the greater the capital, the greater the loss that could be absorbed. On those simple insights a huge regulatory edifice has been erected.

In 1979, after a decade of high inflation and low interest rates, the US Federal Reserve drastically raised interest rates to combat inflation. Meanwhile major commercial banks recycled the deposits from petro-dollars from the high oil-prices to loans to developing countries. The high interest rates caused the 1982-Latin-American-crisis and brought some American commercial banks to the brink of insolvency.

French, German and Japanese bank however were less exposed to the credit risk associated with loans to developing countries and gained a competitive edge against the Americans banks. Between 1982 and 1988, Americans and British tried to agree on a common capital adequacy standard which would take into account the different models of banking business in the various countries. The agreement, called the 1988 Basel Accord, introduced capital requirements which were weighted by the relative riskiness of the asset of the bank.

In his conclusion, Goodhard explains the basic mechanism of crisis-driven financial regulation (p. 62)

Something goes wrong in the financial system, and some people lose money. Almost by definition the existing system of supervision and regulation is to be held at fault. The Press takes up the cry, ‘Heads must roll’. Since the politicians do not want it to be their own heads that become parted from their bodies, they feel the need to be seen to be taking actions to make sure that that particular disaster never happens again.

So financial innovation, and new potential disasters, breed new kinds of regulation and supervision. The key innovation in this respect is, in these last 40 years, been the growing global reach of financial intermediation, via globalization and IT. This causes a real proplem because regulation is about laws, and laws are national in character, whereas financial intermediation is now international.

• Financial supervision
• Bank regulation and money laundering
• Corporate Governance
• Insolvency Regimes
• Financial stability and the EMU
• Cross-Border Payment Systems
• Securities clearing and settlement

Some of these chapters will be discussed in later posts.

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 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.