It is reassuring that the G-20 document is more a re-affirmation of basic principles than a dramatic shift, says SUBIR GOKARN.
The document released by the G-20 at the end of its Saturday meeting reflects a desire to find a balance between dealing with the causes of the current crisis while resisting the temptation to smother the system with over-regulation. The actions that it lays out are based on a set of five principles, that most people would consider unexceptionable. The group is apparently realistic about the constraints under which such a complex initiative will have to work. The window of opportunity for even moderate change, which is what these recommendations essentially are, is typically restricted to the duration of the crisis.
An optimistic scenario is that the various monetary and fiscal stimuli that countries in the group and outside it have activated in recent weeks will put a stop to the downslide and begin a recovery over the next year. If this materializes, commitment to reforms, particularly those involving multilateral co-ordination and compromises on what are seen as sovereign powers, will inevitably weaken. Implicitly acknowledging this possibility, the document prioritizes actions over the next six months related to each of the principles. It also refers to a medium-term agenda, which, in any case, will depend entirely on how much movement there is on the priority actions.
The first three principles are, essentially, a re-iteration of the basic principles of financial regulation. Greater transparency, prudence and integrity are all objectives that the financial system should strive for, regardless of crisis. The articulation of these goals in the document as well as the specific priority actions that have been recommended under them, suggest that the current paradigm was both inadequate and misguided. If so, the document reflects a significant shift in position. The steps recommended offer room for improvement on at least two fronts.
First, there is the intent to both improve and standardize accounting principles and standards for the whole range of financial instruments and transactions, which are seen to have played a significant role in the current crisis. It might be a little too ambitious to expect an entire protocol to be ready in six months, but even getting to a point where outside analysts are able to make a reasonable assessment of these assets and a comparison across financial institutions in different countries will be a significant achievement. A major reason why financial opacity spills over into the real economy is that everybody tends to adopt a “better safe than sorry” position on dealing with counter-parties. The value of credible and standardized disclosures in today’s situation is immense.
Second, while calling for the development of more robust risk management systems over the medium term, it also asks for the immediate upgrading of liquidity requirements, risk measurement and provisioning and the re-orientation of compensation formulae in financial institutions to ensure that they do not encourage excessive risk-taking. There has always been a dilemma in making risk mitigation mechanisms more and more onerous because there is a direct trade-off with profitability in most instances. It is also not very clear whether the current standards on many of these are inadequate.
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What is important, though, is to be able to view the entire set of risk management instruments from a holistic perspective and acknowledge that it is the system is only as strong as its weakest link. The eventual objective is to ensure consistency between all the elements so that they are collectively effective without being individually burdensome. It will take trial and error, but a start has to be made somewhere.
The last two principles may be a little more difficult to translate into effective outcomes. The desire for greater international co-operation and co-ordination is entirely appropriate, both as an ideal and as a functional response to the deep inter-linkages between national financial systems. Global financial institutions cannot but be subject to multinational oversight; the only question is whether this is done in a fragmented or a consolidated way.
But, as we have seen in other multilateral contexts, co-ordination is easier said than done. There is great heterogeneity across economies in terms of the current state of their financial systems, their degree of integration with the global system and their regulatory capacity. Further, financial systems are seen and used as instruments of a larger development agenda, a role which can and does come into conflict with traditional modes of financial regulation.
Significantly, the document asserts the desirability of continuing with multilateral trade negotiations with a view to successfully concluding the Doha Round. It assuages anxieties on the trade front by refusing to consider any protectionist measures while the world economy works its way through the crisis. But, it is these very trade negotiations in which the conflict between sovereign interests and collective goals has been persistent. Similar tensions are very likely to surface in the design of even the most basic regulatory co-ordination mechanism.
The last principle is that the existing multilateral institutions — the IMF and the World Bank — will play an important role in the global economy. To do this they will have to be given both more resources and a different governance structure; one which accommodates the dramatic diversification of economic activity around the globe since the institutions were set up over six decades ago. Here again, while the principle is unobjectionable, a middle ground between powerful emerging economies looking for a far greater say in running these institutions and an old elite reluctant to cede control beyond a point may be difficult to find.
This would be a pity, for two reasons. One, collective solutions appropriately designed and implemented are far more efficient than individual ones. Two, with specific reference to the World Bank, the likely slowdown in private capital flows, which had significantly dis-intermediated that institution in recent years, will restore its role as a financier of critical projects, particularly in infrastructure, in emerging economies.
Overall, the G-20 document reflects the collective belief of the group that the basic principles of effective financial regulation remain so. It is the quality of implementation and the ability to adapt to rapidly changing markets that distinguish between good and bad regulation. The way forward that it offers is more “back-to-basics” solution than a paradigm shift. This may disappoint some people, but will reassure others, who were wary of over-reactions. Of course, only time will tell if the recommended actions are too little or just enough.
The author is Chief Economist, Standard & Poor’s Asia-Pacific. Views are personal