Rethinking Bretton Woods | Sat, Jun 30, 2012
This report provides an assessment of the outcomes of the G20 Summit held in the city of Los Cabos, Mexico, on June 18-19 2012, regarding the global economic recovery, financial regulation and IMF reform.
Click here for a related report on the outcomes of a G20 Study on Macroeconomic Impacts of Commodity Price Volatility, also addressed at the Los Cabos Summit.
The G20 Leaders held their 2012 Summit in the city of Los Cabos, Mexico, on June 18-19. The difficulties of Spain and Italy to refinance their debt, added to the increasingly evident impossibility of Greece to reach anything close to debt sustainability under the conditions of its last bailout took over the discussion. In the same way, last November at the G20 Cannes Summit, the announcement of a referendum in Greece on the eve of the meeting triggered a crisis that moved quickly to the center of the agenda.
The Eurozone crisis thus provided a distraction that spared the G20 a level of scrutiny that would have revealed how unable it has been to provide urgent and strong measures to respond to the worsening global economic juncture, one in which almost no part of the world has been able to avoid downward revisions of growth. The malaise that has haunted the developed world since the financial crisis is now becoming slowing growth also in the emerging markets, including the BRICS which had so far acted as the engine of growth. The International Labor Organization reported that employment remained 50 million jobs short of pre-crisis levels, while just in this and next year alone 80 million more people are expected to enter the workforce. The World Trade Organization foresees trade still growing, but at less than 4 per cent, this year (less than last year, which in turn was less than in 2010).
Global economic recovery
It is fair to say that solving the European crisis is no small piece in addressing the challenges of the global economy. But even by this count, the G20 did not fare well, with a vague pledge by “Euro Area members of the G20 to take all necessary policy measures to safeguard the integrity and stability of the area, improve the functioning of financial markets and break the feedback loop between sovereigns and banks.”
There was no pretense of continuing on the path to reform the international monetary system, a priority of the G20 last year. Without such political will, the range of instruments to promote a balanced recovery really narrows down.
The Declaration‘s support for the required stimulus of demand was also lukewarm, far short of what is needed in the current juncture. The Declaration calls for advanced economies to “ensure that the pace of fiscal consolidation is appropriate to support the recovery, taking country-specific circumstances into account and… address concerns about medium term fiscal sustainability.” It only calls on those advanced and emerging economies which have fiscal space to “let the automatic fiscal stabilizers operate.” And it states that the countries with sufficient fiscal space stand ready to coordinate and implement discretionary fiscal actions to support domestic demand. Even this is only “should economic conditions deteriorate significantly further” and “as appropriate.”
At the same time, under the guise of promoting global recovery, the document calls for a number of measures that may actually deepen recession. This is the case for the agenda on so-called “structural reforms.” The International Trade Union Confederation denounced the “ continuing attacks on wages and collective bargaining structures in parts of Europe and in the US, where several states have outlawed public sector bargaining” as well as “cutbacks in public sector employment.”  Likewise, the G20 Declaration mentions “labor market reforms to boost competitiveness and employment,” using wording that has often been code for labor market flexibility. In their statement the ITUC quotes the OECD’s finding that the push towards “flexible” labour markets is one driver of income inequality.
It is worth noting that in another section of the Declaration this is hedged saying that “quality employment is at the heart of our macroeconomic policies. Jobs with labor rights, social security coverage and decent income contribute to more stable growth, enhance social inclusion and reduce poverty.” But ensuring such proposition can become more than nice rhetoric will take a serious effort to slow down fiscal consolidation and austerity.
The Summit Declaration endorsed a Financial Stability Report that provided a not-so-alarming picture about the pace of progress in implementing the different areas of reform of financial regulation. It reaffirmed the G20 commitment to “timely, full and consistent implementation of agreed policies in order to support a stable and integrated global financial system and to prevent future crises.” There are reasons to doubt, however, the usefulness of the “agreed policies” for the intended outcome.
Let us look at some of them:
Ø Bank capital requirements
On bank capital requirements, the FSB report examined implementation by the 27 members of the Basel Committee on Banking Supervision of Basel II Agreement on capital requirements, Basel II.5 (some reforms on the way of calculating capital in the banks’ trading book and for complex securitizations, whose deadline for implementation was end of 2011) and Basel III (the complete set of reforms approved in 2010). It found that 21 of 27 jurisdictions had implemented Basel II, and only 20 the Basel II.5. Draft regulations for implementing Basel III (which was supposed to be regulated, even if implementation will take several years, by the end of 2012) have only been issued in 20 jurisdictions.
The flaws in the capital requirements paradigm are not apparently up for discussion. Paramount among these is the reliance on banks’ use of internal models for calculation of the risks on whose basis capital needs are estimated. Banks continue to engage in so-called “risk-weight asset optimization,” basically techniques to understate the risk in their balance sheets in order to get away with lower capital needs.
The JP Morgan scandal – a loss of at least USD 2 billion in derivatives bets gone wrong that this firm announced in early May-- awoke many to the major consequences that gaming of these internal models could potentially have. Indeed, central to internal risk management systems are estimations of Value-at –Risk, that is, The latest US regulations for market risk measurements (issued after the JP Morgan incident), some tinkering notwithstanding, keeps Value-at-Risk as the main form of reporting.
Basel III contains a “leverage ratio” which is calculated on the basis of total –not risk-weighted—assets. But this ratio, the one least subject to gaming, has been dropped as a mandatory requirement in the latest proposal by the European Union to implement Basel III.
The practice of US institutions to account for derivatives in their balance sheet on a net, not gross basis, also allows them to understate the capital needs under the leverage ratio. There is little sign of movement to change that, as the FSB reports:
“After considering the comments of stakeholders the [International Accounting Standards Board and the Financial Accounting Standards Board] decided to maintain their current different offsetting accounting models but to improve and converge related disclosure requirements.”
Ø Too big to fail
Regarding the G20 commitment to make sure that “no financial institution is “too big to fail” and that taxpayers do not bear the costs of resolution of any institution that does fail” there are few reasons to be upbeat. The FSB reports on the implementation of “a new international standard for resolution regimes, more intensive and effective supervision, and requirements for cross-border cooperation and recovery and resolution planning reports.”
The new international standard for resolution regimes is a series of features that national systems for resolution of financial institutions should have in place in order to facilitate resolution of “TBTF” not just domestically but also on a cross-border basis. According to the FSB, “national resolution regimes are not fully consistent” with this standard.
“Crisis management groups (CMGs)” involve key regulating authorities of the home country of institutions deemed systemically important and of jurisdictions that are host “to entities of the group that are material to its resolution.” They are only required to “cooperate closely” with other jurisdictions where the firm has systemic presence.
According to the report, CMGs have been established for 24 of the 29 institutions that the FSB has designated as global systemically important ones. In addition to the criticism that the list of institutions of global systemic impact falls rather short, the “colleges” approach to dealing with cross-border companies is subject to criticism because it offers little guarantee that in a situation of crisis smooth cooperation with fair results can be achieved.
In fact, another report by the FSB, on unintended consequences of financial reform in developing countries, does survey the justified fear among regulators in those countries about the “home bias” of reforms. The European Commission also recognized in a 2009 report that “Member States' incentives to co-ordinate and refrain from ring-fencing national assets during a cross-border crisis are limited by their need to protect the interests of national stakeholders.” The limited involvement in CMGs of authorities of host countries, and the absence of more than a cooperation requirement between CMGs and authorities where the firms have systemic presence, all but reinforces such home bias.
The FSB also reports limited progress on the other aspects of the agenda. “Resolution planning, resolvability assessments and cooperation agreements has proved difficult without a clearly articulated resolution strategy“ so the FSB reports to be working on “high level resolution strategies” led by the authorities of the home country that can offer guidance. In turn, the FSB finds that there are, as yet, no institution-specific cooperation agreements consistent with the Key Attributes between the members of any CMG. This is attributed to the fact that “development of a resolution strategy is seen as a prerequisite to such an agreement and also because differing terms and conditions for information sharing across jurisdictions complicate cross-border cooperation.”
In the meantime, the trend towards concentration in the financial sector continues relentlessly. The Federal Reserve of Dallas, for instance, recently stated that “huge institutions still dominate the industry—just as they did in 2008. In fact, the financial crisis increased concentration because some TBTF institutions acquired the assets of other troubled TBTF institutions.”
Ø Derivatives regulation
On the regulation of derivatives markets, the Los Cabos outcome maintains commitments to have, by 2012, all standardized OTC derivative contracts traded on exchanges or electronic trading platforms and cleared through central counterparties. Additional reforms (that seem not to share such deadlines) are to have OTC derivate contracts reported to trade repositories and contracts are not centrally cleared subject to higher capital requirements.
The FSB report is upbeat in its evaluation that, unlike the report before the G20 Cannes Summit, significant progress has been made to implement this part of the agenda. The danger here is that formal progress that can serve to tick boxes does not promote the expected changes of behavior among traders.
The FSB notes that “the jurisdictions currently with the largest markets in OTC derivatives – the EU, Japan and the US – are the most advanced in structuring their legislative and regulatory frameworks.”
But in the US, regulatory bodies stay under fire from the financial industry lobby. “The attacks on derivatives reform have been steady and continuous, including direct pressure on the regulators, efforts to repeal or undermine new transparency and accountability rules in Congress, lawsuits and threats of lawsuits, and – among industry’s most effective levers – depriving the CFTC of the funds needed to actually regulate the industry,” says Lisa Donner, the Executive Director of US-based coalition Americans for Financial Reform, which groups over 250 organizations campaigning for real bank reform based on accountability, fairness and security.
On the scope of the reforms the agencies had to make already some significant concessions. One of these was on position limits, which were set far too high to have any meaningful impact – while even this rule is also being challenged in court. Another was on the size of the traders that are subject to the oversight, only those carrying more than USD 8 billion in trading –while the initial proposal was going to establish that threshold at USD 100 million. Analysts of the European Union efforts identified similar obstacles on the legislation being debated by the European Parliament.
Ø Shadow banking and credit rating agencies
Reform of the more than 30-trillion-large shadow banking sector is another area of the G20 reform agenda addressed by the FSB’s progress report. Before the G20 Cannes Summit the FSB had outlined five areas of reform to be developed by the FSB in 2012, in the following areas: i) The regulation of banks’ interactions with shadow banking entities (indirect regulation); (ii) The regulatory reform of money market funds (MMFs); (iii) The regulation of other shadow banking entities; (iv) The regulation of securitisation; and (v) The regulation of securities lending and repos. Most of these workstreams are yet to produce initial policy recommendations, with the FSB promising that an initial integrated set of policy recommendations will be ready by end of 2012.
The Leaders reiterate the call for progress by national authorities in ending the mechanistic reliance on credit ratings, while the FSB report on implementation finds limited progress on this, too. The FSB report on implementation found that only “a few jurisdictions have passed, or proposed, wide-ranging legislative or regulatory measures to reduce reliance on CRA ratings, but are facing difficulties in detailed implementation.” The difficulties to come up with alternatives to credit ratings demonstrate the hold they still have on financial markets. Nonetheless the G20 called for “transparency and competition among credit rating agencies,” which is still notably different from the commitment in the G20 Seoul Summit, to “strengthen regulation and supervision on … credit rating agencies.”
Regarding reform of the International Monetary Fund, the G20 Summit Declaration reiterated the pledges of last April Finance Ministers’ statement to increase lendable resources of the institution by more than 450 US billion in bilateral loan contributions.
Before this announcement, the IMF members had agreed to raise capital from approximately USD 375 billion to approximately USD 750 billion (an increase whose approval is expected to happen this coming October at the IMF Annual Meetings). In addition, in 2010 the members had pledged bilateral contributions of some USD 500 billion through bilateral credit lines for the IMF. These contributions were to be downscaled once the increase in capital takes effect, in proportion to such increase, to leave total available funds (capital plus bilateral commitments) leveled at approximately USD 875 billion.
The latest G20 Summit outcome says that new pledges are “in addition to the quota increase under the 2010 Reform,” and makes no reference to their additionality to the existing bilateral credit lines. Nonetheless, the pledges are presumably in addition to the existing bilateral commitments and the reason why IMF updates on its website do not register such additional commitments might be that none of them has been formalized in a loan agreement, yet. However, it is hard to tell this early in the process whether they will also be converted into capital or will remain as bilateral lines of credit. If they all are formalized, they will take IMF resources above USD 1.2 trillion.
The progress was not so fast in implementing reforms of the governance of the institution, however. At Los Cabos, G20 Leaders reaffirmed a commitment to implement voting power reforms that were agreed in 2010. But an implementation report released in advance of the Summit revealed a still large gap between what was agreed and the implementation so far. The transfer of two chairs on the Executive Board from developed to developing countries –chairs that would be freed from currently European-run chairs – is similarly stalled.
What is likely the most important piece of the reform, from a structural point of view, is the redesign of the quota formula, and G20 Leaders restated a deadline of January 2013 to complete it, with a deadline of January 2014 to apply the new formula in a new review of quotas. Reports indicate Board members’ positions on the shape of the new quota formula are still far away, and time is running short. It is worth noting that the quota review was already scheduled to happen in January 2011, deadline that was changed to the current one during the Korean Presidency of the G20, in 2010.
Summing up, the G20 seems to emerge as the biggest winner from the European crisis so far. Next Summit is more than a year away –Russia 2013. By removing, once again, the G20 from the spotlight, the Eurozone crisis has helped spare the grouping some difficult questions. It might be that, as claimed by some analysts, Mexico sought to set the G20 on an incremental path to improve economic co-operation and focus on a long term agenda. But this smells more like an attempt to make a virtue out of necessity. Nobody can deny that long term reforms are important and, yet, focusing on the long term at the expense of responding to the imperatives of an emergency would mark an odd turn for the grouping. After all, its main raison d’etre seemed to be its capacity for rapid, unhampered economic policy coordination among those representing 85 per cent of world income.
MEETING. Guadalajara, Mexico, 17-18 May 2012. (“L20 Trade Union Statement”)
 Caliari, Aldo 2012. JP Morgan shatters financial reform illusions (available at https://www.coc.org/rbw/jp-morgan-shatters-financial-reform-illusions-may-2012)
 For instance, it is required for certain exposures some extra capital to account for stressed Value-at-Risk. Federal Reserve System 2012. Risk Based Capital Guidelines: Market Risk. 12 CFR Parts 208 and 225. June.
 Caliari, Aldo 2011. G20 Cannes Summit: Come with a Bang, Gone with a Whimper RBW Occasional Paper (available at www.coc.org/rbw/come-bang-gone-whimper-g20-cannes-summit-november-2011) (“G20 Cannes Summit”)
 FSB 2012. Identifying the Effects of Regulatory Reforms on Emerging Market and Developing Economies: A Review of Potential Unintended Consequences. Prepared by the Financial Stability Board in coordination with Staff of the International Monetary Fund and the World Bank. 19 June 2012.
 European Commission 2009. Communication from the Commission to the European Parliament, The Council, The European Economic and Social Committee, The European Court of Justice and The European Central Bank. An EU Framework for Cross-Border Crisis Management in the Banking Sector. Brussels, October 20.
 Vander Stichele, Myriam 2012. The Conservatives strike back: EU regulations against commodity speculation at risk (available at http://somo.nl/dossiers-en/sectors/financial/eu-financial-reforms/newsletter-items/issue-12-may-2012/the-conservatives-strike-back-eu-regulation-against-commodity-speculation-at-risk)
 Formalized commitments for bilateral credit amount to around USD 500 billion. IMF 2012. Bolstering the IMF Lending Capacity. (Available at http://www.imf.org/external/np/exr/faq/contribution.htm, consulted July 5 2012, last updated June 18, 2012).
 IMF 2012. Proposed Amendment on the Reform of the IMF Executive Board and Fourteenth General Review of Quotas—Status of Acceptances and Consents. Prepared by the Legal, Finance, and Secretary’s Departments. June 12.