International financial stability architecture for the 21st century

Posted by on 31 July 2009

International financial stability architecture for the 21st century

Masahiro Kawai and Michael Pomerleano

In response to the crisis the international financial community has established the Financial Stability Board (FSB). The FSB aims to address vulnerabilities and to develop and implement strong regulatory, supervisory and other policies in the interest of financial stability. The FSB mandate is sweeping. It proposes to: assess vulnerabilities affecting the financial system; identify and oversee action needed to address them; promote coordination and information exchange among authorities responsible for financial stability; monitor and advice on market developments and their implications for regulatory policy; advise on and monitor best practices in meeting regulatory standards; undertake joint strategic reviews of the policy development work of the international standards setting bodies; set guidelines for and support the establishment of supervisory colleges; manage contingency planning for cross-border crisis management; and collaborate with the International Monetary Fund (IMF) to conduct Early Warning Exercises.

The FSB comprises senior representatives of the national financial authorities (central banks, regulatory and supervisory authorities and ministries of finance) in the G20 and a few other countries, international financial institutions, standards setting bodies, and committees of central bank experts. Mario Draghi, Governor of the Banca d'Italia, chairs the FSB in a personal capacity. The FSB is supported by a small secretariat (9-10 staff members) based at the Bank for International Settlements in Basel, Switzerland.

There is considerable skepticism regarding the capacity of the FSB to manage this ambitious agenda. The first concern is straight forward. The FSB is a mere successor to the Financial Stability Forum (FSF), with the same modus operandi and staff, albeit with broader membership. The FSF failed to identify and prevent the US financial crisis and the Eastern European crisis in a small homogenous membership of seven or so major central banks. Therefore it is not entirely clear why there is an expectation that the FSB will succeed where the FSF failed with a far more heterogeneous membership of G20 plus countries, and three to four institutions from each country—ministries of finance, central banks, financial sector supervisors and, in some cases, securities commissions.

There are doubts regarding the independence and analytical capacity of the FSB. Nicholas Stern, writing in the Financial Times regarding global surveillance, states, “Any forthright, disinterested assessment of the global economic system’s stability requires two sorts of independence.” He points out that the institution that is conducting the analysis and making judgments about the stability of the system must not have anything other than its own reputation riding on its assessment. Therefore it must be independent of the G-7. In this light, however, the FSB is a secretariat, without independent analytical capacity. It leads to the second concern that the FSB does not offer the type of independent “high powered” analytical surveillance that is needed at the global level. It does not have the adequate staffing nor does it propose to undertake independent evaluations, as outlined by Nick Stern. It merely collects information from members and disseminates it. There is an inherent contradiction built-in in this approach: country authorities that did not report adverse information in a small setting of 7 or so central banks will likely be far more reluctant to share information in a wider G20-plus setting. The FSB members will not be prepared to share sensitive adverse domestic information with other members, and therefore the discussions will not be substantive.

A third concern relates to governance of the FSB. The Westphalian principles governing international financial oversight are not adequate to address the problems in the contemporary financial system, such as cross border crisis contagion and insolvencies. The self-interest of financial centers, such as London, fails to reflect the global agenda of actively regulating the global financial system, and will inevitably lead to another race to the bottom in regulatory forbearance. It is indicative of things to come that a European regional effort is already unraveling with the U.K. resisting ceding power to the European Union regulatory agencies.

Will the FSB fail? Not necessarily. In order to succeed it needs to lead in several areas. Most importantly, the FSB cannot be an insular organization in Basel. It needs a vision and think outside the box. The FSB needs to leverage effectively regional- and country-based financial stability organizations. The first layers are national financial stability organizations in all the G20-plus countries. The debate on whether those functions belong in central banks is only starting and it is outside the scope of this article to address this issue. For instance, in the US the Federal Reserve perceives the stability function to be directly related to the role of the central bank. For example, in Indonesia, the government has submitted to lawmakers a bill to provide it with extra authority and guidance in preventing possible systemic threats to the financial sector. Under the bill, the Financial System Stability Committee (KSSK), headed by the finance minister, with the central bank governor as a member, will have full authority to take measures in response to threats to the financial system.

Second layers in this architecture are regional financial stability organizations. The European initiative to set up a European Systemic Risk Board as a macro-prudential overseer and a European System of Financial Supervisors as a micro-prudential coordinator is a good example. Asians are discussing the possibility of establishing an Asian Financial Stability Dialogue (AFSD)—among the region’s financial authorities. Such regional organizations in Latin America, Eastern Europe and other regions could serve numerous beneficial functions. They can conduct regional monitoring of key financial products, institutions and markets on the ground, and facilitate regional financial integration. The above mentioned KSSK in Indonesia could benefit from a regional setting to act as a training ground and community of practice for the staff members of national systemic councils in other countries in the region.

Finally, it is important to remember that the global payments imbalances played a key role behind the global financial crisis, if not its direct cause. After the Asian financial crisis many economies in the region started building foreign exchange reserves as self insurance determined not to be caught again in the 1997 situation. For them going to the IMF is a political suicide because of the lingering bad memory of the “IMF crisis” in the mind of the public at large. So these economies had every incentive to accumulate reserves by running large current account surpluses or intervening in the currency markets. Countries in the region would welcome the rebalancing of sources of growth and payments imbalances if an Asian Monetary Fund (AMF) reduces financial turbulence and acts as a lender of last resort. A newly created AMF will work closely with the region’s financial authorities under the AFSD for conducting regional economic and financial surveillance.

In conclusion, the proposed international financial regulatory oversight is not suited to the realities of an interconnected financial system in the 21st century. Far more efforts are needed to ensure the success of the international financial regulatory architecture.

Professor Masahiro Kawai is Dean, Asian Development Bank Institute. He was Deputy Vice Minister of Finance for International Affairs at the Japanese Ministry of Finance from 2001 to 2003. Dr. Michael Pomerleano is Visiting Fellow at ADBI