Rethinking Bretton Woods | Fri, Nov 27, 2009
This article comments on a Discussion Paper by the UK Financial Services Authority that debates with the financial industry about the role of global banks and their alleged benefits for international trade.
In a recent report the UK Financial Services Authority takes issue with the banking industry assertions about the beneficial impacts of global banks. As explored in a previous article, the approach to this issue has important bearing on the success that developing countries can expect to their efforts to put trade to work for development.
The Bank of International Settlements, in its latest annual report, states that the growing jurisdictional fragmentation in supervision authorities, by forcing potentially different and individual requirements on entities operating in each country, “would shrink trade in goods and services and thus moderate growth and development.” In doing so the institution sides with views held by the industry. But in September 2008, as the collapse of Lehman Brothers prompted a crisis of confidence, developing countries with sizeable portions of their banking sectors owned by foreign banks could appreciate the risks entailed by a global banking model.
Transnational banks repatriated resources to their headquarters, and developing countries where they were operating felt the consequences in a painful worsening of terms and access to trade finance and credit in general. The consequences for production and export capacities are likely to be lasting. In this state of affairs, the policy responses to the crisis by home country governments did not help, as bailouts and rescue packages tended to promote satisfaction of more immediate domestic market needs at the expense of the global role of such banks.
Moreover, the crisis came after almost a decade of efforts by developing countries to respond to the demands of what the industrialized world had determined were priorities in reforms to achieve a resilient banking system. After the East Asian financial crisis, the Group of 7’s main response had been the endorsement of 12 standards and codes that were considered critical for a “sound” financial infrastructure and would become the focus of programs for policy reform, surveillance and technical assistance by the international financial institutions and donors. Underlying the financial standards approach is the notion that countries are well advised to remove obstacles to the operation of cross-border banking systems, letting a more efficient and globalized market for finance lead to a more efficient allocation of capital, and limiting themselves to provide the appropriate infrastructure for such capital to move freely.
Following on comments the industry made over the FSA’s previous report, the most recent Discussion Paper does not hesitate to take issue with the view espoused by the banking industry. It questions the argument that fragmentation of global capital markets would undermine the efficiency of allocation of capital resources. One of the arguments it wields is that flows to and from banking subsidiaries, as compared to those to and from bank branches of a centrally managed global bank, can be more stable. “Some emerging markets authorities,” it says, “ argue that it is capital flows to local branches which reversed most rapidly in the current crisis with adverse consequences for local credit availability.”
The report also utilizes the same logic of the critique to argue that not having standalone subsidiaries might call for greater capital surcharges on large global banks, an alternative that may have “more implications for global capital flows (or for the transfer of banking skills and technology through global banking groups).”
The paper is presented as an input to trigger debate on possible responses. However the FSA states as a policy stance that informs its thinking the preference for a capital surcharge that, in the case of global banking groups, could be combined with “an approach … which places greater emphasis on the standalone sustainability of national subsidiaries, with an overt global understanding that home country authorities will not consider themselves responsible for the rescue of entire groups.” In fact, the need for greater capitalization of standalone subsidiaries might have the positive consequence of fostering greater competition in national financial systems, and with it greater diversity. The lack of a diversified banking sector has not served developing countries well in the crisis time.
Perhaps unintendedly, the report touches upon another crucial aspect of the relationship between banking and trade. The report admits that higher capital and liquidity requirements could negatively affect terms and volume of credit. But the damage to economic output is qualified on the basis of whether this will constrain “investments which are required to achieve a sustainable growth rate in line with technical change and population growth.” The qualification carries potentially far reaching implications. The report contends that “constrained credit supply, particularly in periods of strong economic upswing, could prevent investments which subsequently turn out to be unsustainable and a poor use of capital resources.”
In other words, even if the fragmentation of the financial sector so much decried by the industry results in a reduction or higher price of credit, this cannot be necessarily equated to a less efficient allocation of capital. An alternative, possible outcome is that a tighter grip by national supervisors over the capital features of banks operating in their countries could improve the allocation of capital for two reasons. First, it would take it away from a purely market-led approach that, as shown in the crisis, might exacerbate the buildup of bubbles in certain sectors. For developing countries attempting to benefit from trade, this could well mean the difference between a credit profile that works to intensify traditional export sectors and one that works to support non-traditional, more diversified (and more sustainable in the long term) export structures.
Second, national supervisors would have better incentives to decide on the appropriate capital requirements than the centralized management of global banks. The latter would make this decision on global basis and in order to abide by a standard set as a purely aggregate measure. In this regard, it is worth noting the interesting reflection near the end of the FSA paper: “while… the introduction of the Basel I capital regime deliberately aimed at achieving a levelling up of capital standards to good international practice, it was not based on any theoretical analysis of what good international practice should be.” During the subsequent development of Basel II, it was explicitly decided that aggregate levels of capital should remain unchanged. This may not be an innocent omission. It seems that the adoption of a standard for global banks based on aggregate levels of capital, and in a system where banks are left to decide how they meet such aggregate figures (no matter how stringent), in a way is already tilting the balance towards a “global” efficiency, and away from a “national” one. National supervisors, at a significant disadvantage in such a system, may find that the obligation for global banks to maintain subsidiaries that meet nationally-specific capital and liquidity requirements is merely a way to restore balance to the situation they cope with—and even a partial one at that.
 Financial Services Authority 2009. “A regulatory response to the global banking crisis: Systemically important banks and assessing the cumulative impact,” October. (available at http://www.fsa.gov.uk/pubs/discussion/dp09_04.pdf) or “Discussion Paper”
 FSA, 2009. “The Turner Review. A regulatory response to the global banking crisis,” March.
 Discussion Paper, p. 20.
 Discussion Paper, p. 27.
 Discussion Paper, p. 34.
 Discussion Paper, p. 30.