Tuesday, November 11, 2008

The crisis, fragmented architecture, and the unloveable creature

World leaders will soon be meeting in Washington to try and hammer out solutions to the emerging crisis. The world's newspapers are full of editorials about what needs to be done. TJN has its own views, which chime with many of the popular recommendations out there. We should make it clear that we resist relying on quick-fix solutions: we support holistic and long-term reform, taking account not only of the current financial crisis, but also the ecological crisis, global inequalities, and insecurity: all of these things require stronger global frameworks for international cooperation.

This is one of a series of blogs dealing with the emerging crisis, and more will follow. It is not looking so much at the immediate context of the emerging crisis, but at the longer term picture of global finance.

A good place to start might be an article in the September edition of the International Financial Law Review, written by TJN's senior adviser, David Spencer. It starts by remembering the words of former US Federal Reserve chairman Paul Volcker, speaking in April this year.

"Until the New York crisis (in the seventies), the US had been free from any sense of financial crisis for more than 40 years. In contrast, today's financial crisis is the culmination, as I count them, of at least five serious breakdowns of systemic significance in the past 25 years - on average, one every five years. Warning enough that something basic is amiss."

The Bank for International Settlements (BIS), the organisation that watches over the world's central banks, asked in its latest annual report:

"How could a huge shadow banking system emerge without provoking clear statements of official concern?"

Spencer pays a lot of attention to the issue of systemic risk: risks that stem not from the threats to individual firms from their own mistakes, but from the potential for mistakes to be correlated across firms, compromising the entire financial and economic system (which is what has clearly happened.) The article also asks a very basic question, encapsulated in its title "Why did no one do anything?" Just to give one example, the US Federal Reserve recently finalised amendments to a regulation which aim to protect consumers in the mortgage market from unfair, abusive or deceptive lending and servicing practices.

"As such abuses in the US mortgage market were well known before the amendments were proposed in January 2008, why were they so long in coming?"

Quite. The short answer to the question in Spencer's headline, and the BIS' question, is that there are none so blind as those who do not wish to see. And there is no shortage of suspects: predatory mortgage lenders, deregulatory madness, macroeconomic imbalances, credit ratings agencies, audit firms with conflicting interests, off balance sheet accounting, the growth in the "shadow banking" sytem, and more. TJN has added one to the mix, which is related to several of the other culprits: the role of tax havens, which is getting some traction worldwide.

If we are talking about systemic risk, there are three points that need to be considered:
- ideological blindness (as the title of Spencer's article suggests);
- fragmentation of institutions supposed to be dealing with these issues;
- and the huge gaps in regulation: (a lot of the activities that have been going on don't or didn't fall under anybody's purview - and much of the so-called financial "innovation" involved financial wizards seeking out these loopholes - amply and actively provided by tax havens, of course.)

The fragmentation of institutions is crucial. They are fragmented both in terms of their function, but also geographically. Regulation needs to be global, and gaps need to be patched up. Spencer's article focuses on a 70-page report by the Financial Stability Forum (FSF,) noting the complexity inherent in atomised global finance, reflected in the sheer number of recommendations (67) issued by the forum. He added:

"The complexity of implementation is shown by the number and variety of those responsible for implementing the recommendations: market participants, financal institutions, the financial industry, financial industry representatives, national supervisors, national regulators, securities markets regulators, BCBS, Iosco, IASB, IAIS, IAASB, major national audit standard setters, Credit Ratings Agencies, auditors, central banks, the IMF, international committees, investors and their aasset managers and originators, arrangers and distributors."

There has to be an international institution responsible for overseeing financial markets, among other things assessing potential upsides and downsides of new products, in advance of them being licenced to work in the market. Any other solution will see a perpetuation of the huge and powerful industries, with some of the biggest lobbying capacity on the planet, that do little else except exploit the many gaps between these agencies, with harmful consequences.

A financial instrument should not only be regulated, but it must be regulatable. The classic tax haven trick is to split financial structures between multiple jurisdictions, so that each can wash its hands of the overall responsibility for the structure, as we have seen on many occasions. How can it be regulated if nobody has the responsibility to regulate it? This splitting is deliberate, of course, and it must be opposed. An overarching body is essential.

We believe it is important to allow markets to work and to innovate (using "innovate" in the sense of companies constantly finding ways to make better goods and services at lower cost, not in terms of seeking the tax and regulatory loopholes.) But as they innovate, it is important to assess risks. This is just the same principle as is applied by the UK's National Institute for Health and Clinical Excellence (NICE) which assesses medical drugs thoroughly before they go on the market. So it should be for financial markets: let the wizards innovate, within the bounds of what democratic societies accept. Regulation is often the mother of invention: just look at innovation in the vehicle industry as a result of tightening safety and environmental standards. So it can be with finance: and the unproductive innovation, the tax- and regulatory- dodging, must be addressed.

The IMF may well be the right location for such overall oversight. The IMF has many shortcomings, and many people are rightly furious with the policies it has foisted on poor countries. However, we’d love to love the unloveable creature. We don't agree with people who argue that the IMF should be abolished. That is because a body with overarching global, and multifaceted, reach is just essential. No other solution will do. The answer is not to abolish it, but to reform it. And it needs drastic reforms, not only in terms of ideology, but of culture too, so that it is less directly compliant to the whims of industry, and more directly focused on the global public interest. That is, after all, its core remit.

Following this thought, regulators must also have not only the resources, but also the time, to assess risks. As Prof. Jim Stewart recently noted, in the context of massively geared funds run by Bear Stearns and other casualties of the emerging crisis, located in the Dublin International Financial Services Centre (IFSC):

"In Ireland, for example, if the relevant documents are provided to the regulator by 3 p.m. the fund will be authorised the next day. A prospectus for a quoted instrument is a complex legal and financial document (a debt instrument issued by Sachsen Bank ran to 245 pages) so it is unlikely it could be adequately assessed between 3 p.m. and the normal close of business (5 p.m.) Even worse, Luxembourg has a new law stating that as long as the fund manager “notifies” the regulator within a month of launch, the fund can enjoy pre-authorisation approval."

This is quite intolerable. As Stewart notes, this is the result of a regulatory race to the bottom between jurisdictions. The standard solution to the race to the bottom, in any walk of life, is over-arching co-ordination and oversight. And so it must be with international regulation.

This is not to understate the difficulties of getting such a system up and running, especially in an international environment where malign forces supported by tax havens will fight hard to undermine international co-operation wherever they can. But to argue against international co-operation because it is difficult is a bit like arguing against tackling sex trafficking because it is difficult to do. No: it is reason to try harder.

We're not going to get into detailed remedies in this blog. Here are a few ideas. One is that the IMF, or some related institution, should have responsibility for capital market issues, tackling capital flight, etc. The great economist John Maynard Keynes and Harry Dexter White, two key architects of the Bretton Woods institutions both saw this as an issue of over-riding importance. Here is how it is described in a recent book about capital flight:

"In their initial drafts of the Bretton Woods agreements, both Keynes and White required the governments of countries using capital controls about foreign holdings of the latter's citizens. . . . (this was) strongly opposed by the US financial commuity which had profited from the handling of flight capital during the 1930s and which feared that the proposals would affect New York's reputation as an international financial centre. In the face of this opposition, the final IMF Articles of Agreement contained watered-down versions of Keynes' and White's initial proposals. Co-operation between countries to control capital movements was now simply permitted, rather than required (Article 8-2b)."

Another important move is that the UN Tax Committee should be strengthened to intergovernmental status, as a stepping stone to its becoming stronger and more influential, amplifying developing countries' voices in the international tax arena. The road map for a process for strengthening and upgrading the committee should be laid out, to give this committee the role of shaping international frameworks for co-operating on tax matters, for resisting tax competition, for effective taxation of multinational companies, and so on.

Amongst other things, the UN Tax Committee should examine the European Union's Savings Tax Directive, which despite its flaws (which need urgent fixing) should provide the model for a global standard on tax information exchange. With the right mix of political will and the clever use of modern information technology, this could be achieved within a relatively short timeframe. The EU's model, based on automatic information exchange, is in contrast to the distinctly sub-prime approach adopted by the OECD, which our FT comment article not so long ago put like this:

"The OECD’s approach to tax transparency requires information to be exchanged with other jurisdictions only on request. In other words, you must know what you are looking for before you request it. This is shockingly inadequate. We need the automatic exchange of tax information between jurisdictions and all developing countries must be included."

The OECD staffers are smart people, and they know full well that the EU approach is vastly more effective as a deterrent to tax evasion.

Another important issue concerns the arcane-sounding, but hugely important, International Accounting Standards Board (IASB.) This November 2007 blog outlines some of our key concerns about it. It is extraordinary that this has been allowed to develop, almost entirely outside the view of global civil society. Is it really appropriate for a private financial company, registered in the U.S. secrecy jurisdiction of Delaware, to have this absolutely crucial supporting role in public policy? As with the IMF, we don't want it abolished: we want it democratised and made responsive to public policy concerns, not narrow industry ones.

Non-cooperating states should be subject to strict sanction, e.g. loss of access to banking wire system. And so on. There is so much more to do. The world is waking up, but too slowly still. As indicated, this blog takes an approach that is relevant for the long term, and has somewhat less focus on the short term responses to the current crisis. More on the short term approaches, in due course.


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