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.

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 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.

Systemic risk is defined as…

a negative externality that imposes costs on society at large.

The aim of prudential regulation is to contain various kinds of risks, such as credit risk, concentration risk, market risk, settlement risk, liquidity risk, and operation risk.

The regulator’s taks is to internalize the negative externality of risk, ensuring that investors take into account the risks their activities impose on society.

Financial conglomerates, which is according to the authors the attempt by banks to manage risks, diversify earnings by investing in various jurisdictions, make it more and more difficult for national regulators to contain the risk and to avoid contagion.

In the post-Bretton-Woods-Era, banks and financial instutions have adopted innovative financial instruments to diversify earnings and to hedge against credit and market risk.
[Is this really the case? Wasn't it rather to hedge primarily against exchange rate movements?]
This has led to increased international banking activity and to the rise of multifunctional universal banks. These developments [produced] economic growth and development. But they also made financial institutions more dependent and exposed to systemic risk [...]. [T]hese forces of financial globalisation [led to] efforts to strengthen the institutional framework of financial regulation.

They define Global Financial Governance using three principles (p.15):

• Effectiveness in devising efficient regulatory standards and rules
• Accountability in the decision-making structure and chain of command
• Legitimacy (those subject to international regulatory standards have participated in creating them.

None of these three dimensions are particular to financial markets, so the authors introduce (p. 16) the concept of Systemic Risk, which is an underpricing of risk that spreads through the markets. According to the authors, financial regulation has the task to promote the efficient pricing of risks.

The authors follow (p. 17) the route of Political Economy (especially Douglas North) and Game Theory (especially Robert Axelrod) by looking at the role of institutions in financial regulation. However, in Game Theory and Political Economy, institutions are often defined as “regularities in social behavior” (Axelrod: 1984). Accordingly, international institutions can be defined as “a set of rules that govern the ways in which states cooperate and compete with each other” (Kahler: 1995).

Such a definition would also encompass all kinds of informal or tacit arrangements and agreements. But the authors add a legall dimension to their definition of International Financial Institutions (IFIs). Applying the concept of an institution to the current financial architecture, the authors state “international public- and private sector bodies that are involved in setting standards and rules to govern financial markets” (p. 17) have been created. In other words, the authors use the concept of “institution” dynamically: regularities of behaviour will lead to a set of rules which in turn create a public or private body receiving the mandate to create further rules.

Normally, “global governance” is defined in opposition to “global government”: in the absence of any clear-cut global institutions to act as legislative, executive and judiciary, states create binding international rules. “Global governance” is the process of creating “global institutions” without a “global government”.

The authors however chose to discuss the shortcomings of “Global Governance” in a principal-agent-framework through the “creation and operation of rules at [international] level through the involving transnational and subnational actors” (p. 18). These rules are intended to avoid systemic risk and create financial stability, a “public good [which] will never be provided adequately by the market without regulatory intervention” (p. 18).

Despite their economic background, the authors interestingly seem to have a different notion of “public good” than often used in economic textbooks. Normally, a public good is a non-rival, non-excludable good which means that everybody can have access to it and consuming the good does not diminish the possibility of other users to access it. Yet there are some arguments why financial stability does not necessarily need public regulatory intervention, and even with public regulatory intervention is not necessarily a non-excludable good.

The authors definition of “financial system” clearly shows the ambiguity of having to use a different understanding of a public good. They define a financial system (p. 20) through:

1. the extent of intregation of relevant financial sectors
2. the scope and design of financial regulation and legislation

The authors would hopefully agree that in this sense of financial governance, financial stability becomes a public good for a certain financial systems that are defined through integration and legislation. Global financial governance is providing a public good of financial stability through global integration and global legislation (for instance by setting standards).

In the traditional meaning, a public good does not necessarily need public intervention or regulation, it can be provided by markets if some market participants are willing to bear the costs. In fact, throughout modern history, financial stability has been provided by market participants as often as by governments. For instance, before the introduction of the US Federal Reserve Bank, large banks such as JP Morgan acted as Lender of last ressort when other systemically important banks were threatened to fail.

Financial stability is also not “non-excludable”. Even in globalized financial markets financial stability can be restricted to certain legislations. Admittedly, financial stability needs to provided on the global level to be effective because contagion mechanisms can undermine the efforts of creating zones of financial stability. Financial stability is not a black-and-white-public good, which can only be provided or not provided. Financial stability can be provided to a certain degree, and the choice of degree excludes certain actors in the financial systems.

It is so far the most comprehensive review of the International financial architecture. John Eatwell, one of the authors, is using the book for advocating strongly for a World Financial Authority. In the light of recent turmoils in the financial markets, the books focus will help to reassess the proposals made for reform of financial regulation.

An interesting story is the cover of the book. It shows the painting “The Two Tax Gatherers” (ca. 1540) by Marinus van Reymerswaele. Superficially, the painting would fit the topic of the book because it shows two people counting money.

On the other hand, Flemish Renaissance painters often sold their paintings to the same people they mocked for their greediness and desire for money: wealthy merchants and traders. Maybe unintentional the authors of the book are also mocking those which are supposed to read the book: financial regulators.