G20 leaders met in Pittsburgh on 24-25 September and released a communique about the path forward. It is long and covers a very broad range of issues from financial stability to climate change and to development strategies. The key message is that G20 become the top official decision-making body and the global governance scheme should reflect the 21st century power structure, not the past, although the pace of rebalancing – quota and vote in the IMF – remains slow and uncertain.
With respect to financial stability leaders voiced a need to increase capital in financial institutions, create powerful international supervision networks to control large transnational financial institutions, create better and tougher regulation (unified across major financial centers) and control bankers compensation, to reduce excessive risk. It is also welcome that simple leverage ratio will be imposed to reduce taking excessive leverage (asset to capital) that reached 60 !!! in some large financial institutions.
We will see how implementation proceeds, as it did not come unnoticed that US leader was verbally committed to free trade and WTO agenda and at the same time levied additional duties on Chinese tires. It is not forgotten, that IMF has impressive agenda for fighting global imbalances agreed among five powerful members of the G20 in 2006, and just few months later not only abandoned the agenda, but moved fast in the opposite direction (e.g. regarding US fiscal imbalance).
So far so good, but I think that G20 leaders “forgot” about one crucial issue, that will backfire in the next few years. One of the key reasons of the present financial crisis is huge complexity of financial derivatives, which creat rsik that nobody fully understands, including creators of this risk (large banks) and including regulators. We should also remember, that prime factor leading to creation of financial derivatives is REGULATION (to avoid paying taxes, to optimize between jurisdictions, etc.)> In my view the current policy direction is towards MORE REGULATION and towards MORE COMPLEX REGULATION. For example tough regulation on bankers’ pay will immediately result in new, more complex pay structure, that will aim at maintaining income levels (which are outrageous indeed). Therefore what is lacking in the G20 policy direction is a drive towards SIMPLICITY in financial markets.
In good old days we had 3-5-3 banking. Banking was simple, almost dull business. We took deposits at 3%, gave loans to client we knew at 5%, and went play golf at 3 PM. 3-5-3 simple banking. Today we employ math and physics Ph.Ds to create banking products. It is high time to go back to SIMPLICITY and to 3-5-3 banking. Therefore I see very little hope for decent progress, for decent reform, and for avoiding crisis-prone environment unless we properly eliminate the key factor behind future crises, which is excessive COMPLEXITY of financial instrument. To achieve simplicity we need LESS REGULATION, not more, and we need SMART GLOBAL REGULATION. G20 leaders so far failed to grasp this simple truth, and, unfortunately, seem to march in the opposite directions of more complex regulation.
Another issue that escaped G20 leaders attention is CONCENTRATION of financial activity. So far large banks took over other large banks that failed to survive on its own. This is dangerous as large concentration of power of financial institutions was another key reason behind the crisis, for example powerful banks were able to influence regulation, were able to agree on rules of the game, to mention the fourteen powerful families from the Superclass, David Rothkopf book. Without solving the issue of concentration and complexity we will continue to live in dangerous times.
I would suggest two issues to be put on the global agenda for Canada meeting – LESS COMPEXITY and LESS CONCENTRATION:
- G20 is too many to take binding decisions, have you ever see a company managing board with 20 members that is effective. With respect to financial stability there should be a much smaller group that provides recommendations to leaders. A good starting point would be to form a Global Financial Products Forum, that would make recommendations on the path towards SIMPLICITY in the area of financial products. It’s members should be USA, UK, Eurozone, China, Japan and representative of the world of Islamic finance. The mandate should be delegated to people who understand the global financial landscape and have experience in central banking or financial regulation, for example: Frederick Mishkin (USA), Willem Buiter (UK), Otmar Issing (Eurozone) , Yi Gang (China), and equally well qualified senior figures from Japan and the world of Islamic finance
- GPFP presents a typology of financial risk that should suffice the needs of real businesses around the world regarding financing and asset allocation.
- Anything outside this scope is subject to small Tobin tax levied on every transaction above certain size. Revenues from this tax are used to fund the global regulatory body, which employs the best minds in the financial sector, such that their competencies and skill far outpace skill of those who create toxic financial instruments. Only when regulators have global reach and are very well paid, they will be able to act timely and effectively
- Actions should be taken to break biggest financial institutions into smaller units, and in order to prevent the effect of “too interconnected to fall” we should design effective circuit breakers, to prevent domino effects.
We all want effective and safe financial markets. In the past decades effective meant less safe. It is high time to reverse this dangerous path. The only way to achieve this is less complexity and less concentration. We should return to 3-5-3 banking.