The Group of Twenty's (G-20) "Summit on Financial Markets and the World
Economy," held in Washington on November 15, gave world powers a chance to
coordinate their responses to the burgeoning international financial crisis and
accompanying ills in real economies around the globe but produced a long,
vague, and telling declaration, devoid of meaningful commitments to change
business as usual.
The G-20 includes large developing countries like China, India, Indonesia,
Mexico, Brazil, Argentina, and South Africa, so the meeting did at least expand
participation beyond the limited scope of typical Group of Eight (G-8)
meetings, which include
only the world's richest countries plus Russia. At the same time, most
countries of the world (including all of Africa, except South Africa), were
excluded. Civil society groups criticized it for bypassing the more inclusive
United Nations.
The declaration, released after the summit, got short shrift in a busy news
cycle that's lurching from one massive bailout maneuver to the next. But it's a
significant - and contradictory - document. On the one hand, it identifies
regulatory and financial institution failures, and calls for new regulatory
measures. On the other hand, it includes various odes to the free market and
urges forward some of the institutions and processes that helped create the
financial and economic crisis. Unfortunately, while the declaration identifies
important regulatory failures, almost all its action items are at a level of
generality that make them impossible to measure and potentially of little or no
consequence.
Absent altogether from the declaration are big ideas and proposals for
structural shifts. Also notably absent is a commitment to shrink the financial
sector, so that it serves rather than engrosses the real economy. Here's a
detailed analysis of many of its key passages.
Common Principles for Reform of Financial Markets: Regulators must ensure
that their actions support market discipline, avoid potentially adverse impacts
on other countries, including regulatory arbitrage, and support competition,
dynamism and innovation in the marketplace.
The first half of the sentence is a welcome, if somewhat innocuous,
characterization of the job of financial regulators: They should help financial
markets check risky behavior by making sure risks are fully disclosed, and they
should avoid a race to the bottom in regulatory standards ("regulatory
arbitrage"), in which big financial institutions drive down standards in one
country by complaining that they are too tough as compared with another
country.
But the second half of the sentence commits financial regulators to
perpetuating existing problems. In general, innovation is crucial to economic
development, but not "innovation" in the financial markets. The current
financial crisis stems in part from too much innovation - too many complicated
and exotic financial instruments growing too fast, with too little supervision,
too little understanding by market participants of what they are doing, and too
little comprehension by anyone of the systemic threats posed by new
instruments.
In general, we need less dynamism and innovation in financial markets. The
evidence of the last decade strongly suggests the need to prohibit certain
financial instruments altogether, and to require that new financial instruments
pass regulatory review before being permitted to be introduced on the market.
Credit Ratings: We will exercise strong oversight over credit rating
agencies, consistent with the agreed and strengthened international code of
conduct.
Credit ratings agencies - the leading ones are Moody's, Standard & Poor's,
and Fitch - played a central role in the financial crisis. As banks and
investment banks packaged home mortgages and other loans, investors looked to
ratings agencies to assess the level of risk in these combination investments.
The ratings agencies gave the highest rating, AAA, to debt obligations that
quickly proved to be of low quality. Credit ratings agencies have additional
power because regulatory rules say that banks investing with borrowed money
need to set aside less collateral to buy higher-rated instruments.
Internal documents from ratings agencies show what a shoddy job they did. The
US House of Representatives Committee on Oversight and Government Reform
procured a 2007 document in which the head of Moody's stated, "analysts and MDs
[managing directors] are continually 'pitched' by bankers, issuers, [and]
investors" and sometimes "we 'drink the Kool-Aid'." An S&P employee wrote,
"It could be structured by cows and we would rate it." Another S&P employee
stated: "Rating agencies continue to create [an] even bigger monster - the CDO
market. Let's hope we are all wealthy and retired by the time this house of
cards falters."
The ratings agency failure wasn't a matter of incompetence. Ratings agencies
are paid by the entities floating a bond. They have an incentive to please the
entity, to make sure they get repeat business.
Stronger regulation can help reduce this problem. In the United States,
amazingly, the Securities and Exchange Commission must give passing grades to
credit rating agencies that apply their principles correctly, even if the
underlying rating principles are flawed. But even stronger regulation cannot
overcome the structural bias by credit ratings. The problem could be solved by
making credit rating a public function, with government or nonprofit entities
assigned to do particular ratings jobs, without the ability of a bond issuer to
choose who will rate its bond.
Executive Excess: In consultation with other economies and existing
bodies, drawing upon the recommendations of such eminent independent experts as
they may appoint, we request our Finance Ministers to formulate additional
recommendations, including .. reviewing compensation practices as they relate
to incentives for risk taking and innovation
Compensation practices in the financial sector are a key problem. Excessive pay
has helped drive a culture of inequality, encouraging other CEOs and executives
to demand lavish salaries. It's outrageous for public bailout monies to be
spent on massive compensation packages; on principle, the leaders of failed
institutions should be penalized, especially if their vast pay packages are
theoretically tied to performance and shareholder value during boom times.
More important, however, is the issue the declaration does directly raise:
financial sector compensation systems reward risky, short-term behavior and
even provide incentives for management recklessness.
Wall Street bonuses are paid on a yearly basis. If your firm does well, and you
did well for the firm, you get an extravagant bonus. This is not a few thousand
dollars to buy fancy Christmas gifts. Wall Street bonuses can be 10 or 20 times
base salary, and commonly total as much as four-fifths of employees' pay. In
this context, it makes sense to take huge risks, whatever the risk of failure -
and especially if the failure is likely to occur sometime in the future
(meaning any time after this year). The payoffs from benefiting from a bubble
are dramatic, and there's no reward for staying out.
However, to do something about excessive compensation, you have to be serious
about it. The US$700 billion US bank bailout required measures to deal with
excessive compensation. The Treasury Department's executive compensation
guidelines for banks participating in the bailout are laughable. The most
important rule prohibits incentive compensation arrangements that "encourage
unnecessary and excessive risks that threaten the value of the financial
institution". Do banks need to be bribed with hundreds of billions of dollars
to persuade executives not to adopt incentive schemes that threaten their own
institutions with unnecessary and excessive risk?
A meaningful standard must be much tougher. One desirable approach would not
only cap top pay levels, but insist that large bonuses must be tied to company
performance over a long period (say, seven years).
Market Cheerleading: We recognize that these reforms will only be
successful if grounded in a commitment to free market principles, including the
rule of law, respect for private property, open trade and investment,
competitive markets, and efficient, effectively regulated financial systems.
These principles are essential to economic growth and prosperity and have
lifted millions out of poverty, and have significantly raised the global
standard of living. Recognizing the necessity to improve financial sector
regulation, we must avoid over-regulation that would hamper economic growth and
exacerbate the contraction of capital flows, including to developing countries.
Perhaps the Bush administration required this invocation of "free market
principles" as a condition of signing on to the overall document.
It's hard to imagine how anyone could avoid breaking out with disbelieving
laughter upon reading this. As of late November, Bloomberg calculates, the US
government will have committed $7.76 trillion - more than half of GDP - in a
bewildering array of bailout monies, swaps, guarantees, discounted loans,
insurance programs, share purchases and more. Where, oh where, is the "free
market" in this? And doesn't the public have a right to demand control
commensurate with the support the government is offering financial and
nonfinancial firms?
Trade Rules: We underscore the critical importance of rejecting
protectionism and not turning inward in times of financial uncertainty. In this
regard, within the next 12 months, we will refrain from raising new barriers to
investment or to trade in goods and services, imposing new export restrictions,
or implementing World Trade Organization (WTO) inconsistent measures to
stimulate exports. Further, we shall strive to reach agreement this year on
modalities that leads to a successful conclusion to the WTO's Doha Development
Agenda with an ambitious and balanced outcome. We instruct our Trade Ministers
to achieve this objective and stand ready to assist directly, as necessary. We
also agree that our countries have the largest stake in the global trading
system and therefore each must make the positive contributions necessary to
achieve such an outcome.
Existing World Trade Organization rules (in the General Agreement on Trade in
Services, or GATS) already impede the ability of countries to maintain
appropriate financial sector regulations, and new GATS proposals would further
restrict countries' ability to maintain or adopt sound financial regulations.
As a "development" matter, the WTO's Doha Round of trade talks promises
developing countries benefits in the form of improved market access to rich
countries, including the United States. But the inherent shortcomings of this
model are now apparent, as the poor countries that depend on the revenue they
get from exporting to rich countries are experiencing deep trouble due to their
integration with shrinking economies.
Even worse, in the last quarter century, the export-oriented development model
has really been based on sending products to the United States. Even apart from
the global recession, the United States will be a shrinking market, because the
country's trade and current account deficits are not sustainable. Thus the
development potential of an export-oriented economic model is poor.
Millennium Development Goals: We are mindful of the impact of the current
crisis on developing countries, particularly the most vulnerable. We reaffirm
the importance of the Millennium Development Goals, the development assistance
commitments we have made, and urge both developed and emerging economies to
undertake commitments consistent with their capacities and roles in the global
economy. In this regard, we reaffirm the development principles agreed at the
2002 United Nations Conference on Financing for Development in Monterrey,
Mexico, which emphasized country ownership and mobilizing all sources of
financing for development.
The Financing for Development (FfD) initiative has evolved into something more
than a call for money for development aid. At the end of November, country
representatives were to gather in Doha, Qatar to review a proposed document,
following up on the original Monterrey FfD meeting, calling for a review of the
"international financial and monetary architecture, and global governance
structures".
In the eyes of many critics, the G-20 process aims to head off developing
countries' demands for a more fundamental review and
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