He starts with an interesting claim:

Economics normally provides rather dismal news, emphasizing tradeoffs among objectives and hard choices. In the case of redesigning the global financial architecture, however, such is not the case. It is not difficult to construct a set of mechanisms that resolve problems of illiquidity (by providing a responsive lender of last resort facility) while avoiding the governance and incentive problems attendant to counterproductive bailouts of risk takers.

Critique of the Global Financial Structure

The particularity of the financial crises in the late 1990s was the simultaneous collapse of banks and fixed exchange rates. Calomiris says that these were the reasons for these crises:

1. Counterproductive financial bailouts of insolvent banks, their creditors, and debtors by governments, often assisted by the IMF, at large social costs because of the transfer of resources from average citizens to wealthy risk-takers through taxation and thus encouraging excessive risk-takings by banks and corporations relying on the financial safety net by governments.
2. Asymmetric information about the incidence of observable shocks within the financial system, especially when combined with short-term debt finance can magnify the economic consequences of fundamental shocks by leading to a liquidity crisis or bank runs especially in emerging market economies, which can however be avoided if investors hold a diversified bundle of securities.
3. The expectations of speculators can exaggerate the effects of adverse shocks, and can even precipitate self-fulfilling financial collapses when weakened financial systems are also illiquid, which can be avoided if countries have enough reserves.
4. “Contagion” across countries in securities and loan markets increases the severity of the crisis.
5. Because of IMF protection, the costs of liquidity risk from government depending on short-term debt are not internalized

He concludes:

When a country suffers a banking system-cum-exchange rate collapse, its government protects politically influential domestic stakeholders by bailing out banks, their debtors, and their creditors, all at the expense of taxpayers. IMF loans to countries suffering financial collapse serve as bridge loans to permit the rescheduling of debt. The conditions imposed by the IMF along with its financial support help to ensure that tax increases to finance the bailout will be forthcoming, making the IMF an accomplice to the transfer of wealth from taxpayers to domestic oligarchs and global lenders.

Instruments for a stable global financial system

According to Calomiris, regulation ought to avoid the moral-hazard problems and protect against the four “liquidity” problems that can magnify fundamental shocks. There is a need to find a balance between liquidity assistance and market discipline.
In order to find that balanced global financial safety net, three “tranches of risk” must be defined: private exposure, government exposure and international (IMF-type)-exposure to risk.
Bank regulation consisting of capital requirements, “reserve” requirements, deposit insurance and “free banking” (capital market liberalization for financial institutions that comply with regulatory standards. These regulatory requirements should be mandatory for IMF membership, Calomiris argues, to provide a credible first tranche of private loss by ensuring that uninsured bank claimants (stockholders and subordinated debt holders) will lose wealth when banks suffer adverse shocks to the values of their risky assets. Minimum cash reserve ratio requirements ensure a margin of protection for insured debt), and also enhance bank liquidity. Minimum amount of “global securities” helps to diversify bank risk.
For the government exposure to risk, he wants the IFM to set standards for debt management and exchange rate policy, central bank reserve requirements, and require governments to allow banks to offer accounts denominated in both domestic and foreign currency)
The IMF role would be to provide liquidity to central banks in cases of speculative attacks against an exchange rate peg. He proposes that the IMF operates a discount window when lending to central banks which are normally solvent, but at a penalty rate. The IMF would finance the lending by borrowing cash from the central-banks.
Calomiris acknowledges that sharing reaching a system is not easy, especially since it will be strongly objected by governments, central bankers, banks and regulators.

In this post, the main recommendations are going to be listed and assesses whether they have been implemented.

IMF

• The IMF should serve as quasi lender of last resort (LOLR) to emerging economies.

  The IMF is acting less and less as LOLR to emerging economies. Most loans to emerging economies hit by the Asian or the Russian crisis have been paid back (see paper by William Cline). To become LOLR, the IMF would need more funds and more access to supervision, as Olivier Jeanne and Charles Wyplosz argue in this IMF paper.

• Eligible member countries must permit freedom of entry and operation for foreign financial institutions.

  Financial integration of emerging economies has increased to some extent – mostly in Europe, leastly in Latin-America and Asia in the middle (see BIS-Paper by Alicia García-Herrero and Philip Wooldridge. The main integration was regional rather than global.

• Every country that borrows from the IMF must publish, regularly and in a timely manner, the maturity structure of its outstanding sovereign and guaranteed debt and off-balance sheet liabilities.

  Measuring public debt is not an easy taks because of the different types and issuers of public debt. The BIS, the World Bank, the IMF and the OECD maintain the Joint External Debt Hub which collects and publishes information about sovereign debt. A list of central government debt for 89 countries between 1991-2005 is available at the Inter-American Development Bank.

• Commercial banks must be adequately capitalized either by a significant equity position, in accord with international standards, or by subordinated debt held by non-governmental and unaffiliated entities.

  Standards for minimum capital for banks and other financial institutions are given by Basel II, but the final decision on how to implement Basel II was not reached until July 2007.

• The IMF in cooperation with the BIS should promulgate new standards to ensure adequate management of liquidity by commercial banks and other financial institutions so as to reduce the frequency of crises due to the sudden withdrawal of short-term credit.

  The adequate bodies would not be the IMF and the BIS, but the BCBS and other international bodies such as IOSCO or IAIS.

• The IMF should establish a proper fiscal requirement to assure that IMF resources would not be used to sustain irresponsible budget policies.

  The IMF has introduced and updated several codes for fiscal transparency.

• The IMF should use its policy consultations to recommend either firmly fixed rates (currency board, dollarization) or fluctuating rates.

  Just like in 2001, the world is still far away from completely floating exchange rates for all currencies (see IMF overview of Exchange Rate Arrangements in 2006).

• The IMF should cease lending to countries for long-term development assistance (as in sub-Saharan Africa) and for long-term structural transformation (as in the post-Communist transition economies). The Enhanced Structural Adjustment Facility and its successor, the Poverty Reduction and Growth Facility, should be eliminated.

  The Poverty Reducation and Growth Facility is still active. Togo has been the most recent recipient in April 2008.

• The IMF should write-off in entirety its claims against all heavily indebted poor countries (HIPCs) that implement an effective economic development strategy in conjunction with the World Bank and the regional development institutions.

  Through co-operation of creditors in the Paris Club and together with IMF and World Bank, several debt relief initiatives for heavily indebted poor countries have been implemented. The IMF estimates that about 40% of debt has been cancelled.

• Further quota increases for the IMF are not necessary.

  Adjusting quota shares is necessary to reflect the economic development of various IMF Members. Often this was done by increasing quota for some countries. If the USA wants to keep its defacto veto of having more than 15% of votes, then it also needs to increase its quota.

  The Development Banks

• The development banks must be transformed from capital-intensive lenders to sources of technical assistance, providers of regional and global public goods, and facilitators of an increased flow of private sector resources to the emerging countries.

  The World Bank has programs for technical assistance and co-operation with the private sector through the International Finance Corporation.

• The focus of their individual financial efforts should be on the 80 to 90 poorest countries of the world that lack capital market access.

  This would not only be counterproductive, because the World Bank provides technical assistance along with financial help, but it would also set the wrong incentives because countries with difficult capital market access would then stop their efforts to achieve that goal.

• All resource transfers to countries that enjoy capital market access (as denoted by an investment grade international bond rating) or with a per capita income in excess of $4000, would be phased out over the next 5 years.

  Poverty and a good bond rating are not mutually exclusive. Often countries might still be in financial need even though their treasury bonds might have excellent ratings. This proposal contradicts with the previous one, because some countries have access to bond markets but their per capita income is well below US-$ 4000.

• In poor countries without capital market access, poverty alleviation grants to subsidize user fees should be paid directly to the supplier upon independently verified delivery of service. Costs would be divided between recipient countries and the development agency. The subsidy would vary between 10% and 90%, depending upon capital market access and per capita income.

  The World Bank is more and more engaging with the private sector and funds directly the supplier. Often however governments supply certain goods and then financial support from the World Bank becomes an indirect transfer of funds to goverments.

• The government of each developing economy would present its own reform program for institutional change which would be supported by the World Bank and audited independently.

  Institutional change needs to go along with changes in social and political norms. The problem is not drafting a reform agenda, but implementing them and creating the mechanisms for a continuous evolution.

• To underscore the shift in emphasis from lending to development, the name of the World Bank would be changed to World Development Agency. Similar changes should be made at the regional development banks.

  A name change has not occured and would most likely be strongly contested by United Nations institutions reponsible for development.

• All country and regional programs in Latin America and Asia should be the primary responsibility of the area’s regional bank.The World Bank should become the principal source of aid for the African continent until the African Development Bank is ready to take full responsibility. The World Bank would also be the development agency responsible for the few remaining poor countries in Europe and the Middle East.

  There is still considerable overlap between the various regional development banks.

• The World Bank and the regional development banks should write off in entirety their claims against all heavily indebted poor countries (HIPCs) that implement an effective economic development strategy under the Banks’ combined supervision.

  See above to a comment on the similar IMF reform proposal.

• The United States should be prepared to increase significantly its budgetary support for the poorest countries if they pursue effective programs of economic development.

  Even though the USA is the largest donor of development aid, compared to its economic power it only donates a marginal amount to development (about 0.17% of GNI)

The Bank for International Settlements

• The Commission recommends that the BIS remain a financial standard setter.

  The main standard-setting bodies are the BCBS, the IOSCO, the IASB, the IAIS and the FATF. All cooperate with the BIS, but are not the same.

• Implementation of standards, and decisions to adopt them, should be left to domestic regulators or legislatures.

  Especially in Europe, the Commission was a driver of implementation of already negotiated standards, thus it is not always clear whether national discretion to implement at will is the best way to establish international standards.

• The Basel Committee on Bank Supervision should align its risk measures more closely with credit and market risk.

  Basel II is the attempt to do exactly that.

The World Trade Organization

• Rulings or decisions by the WTO, or any other multilateral entity, that extend the scope of explicit commitments under treaties or international agreements must remain subject to explicit legislative enactment by the U.S. Congress and, elsewhere, by the national legislative authority.

  WTO Agreements have to be ratified and implemented in national legislation, but non-compliance can be countered by sanctions and other enforcement mechanism. Whether the Dispute Settlement Mechanisms at the WTO undermine national sovereignty or create a fair playing field for all countries under international trade law is a different matter.

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

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).