This is an author version of the contribution published on:
Review of International Political Economy,
2010, 17 (1), pp. 155-171. doi: 10.1080/09692290903507664
The definitive version is available at:
http://www.tandfonline.com/doi/abs/10.1080/09692290903507664?
journalCode=rrip20#.UxYny6XnXG4
Back to the Drawing Board: The International Financial Architecture Exercise
Review Essay
Tarullo, Daniel K. (2008) Banking on Basel: The Future of International Financial
Regulation.Washington D.C., Peterson Institute for International Economics.
Walter, Andrew (2008) Governing Finance: East Asia’s Adoption of International Standards. Ithaca, Cornell University Press.
During the last several months, we have witnessed one of the most trying times for financial markets in several decades. The financial crisis, which burst in the U.S sub-prime mortgage market and propagated to the global economy, has once again demonstrated the risks associated with the integration of worlds’ capital markets. Indeed, like the financial crises that swept the emerging market countries in the 1990s, the crisis that sparked in one of the most sophisticated financial systems in the world has shown the vulnerability of national economies to shocks originating outside their domestic financial systems. As several advanced countries have entered into recession, it has become frequent to hear talks of de-globalization. That is to say, the 1990s consensus on the benefits of global financial integration and on the role of markets in ensuring systemic stability seemed to have been called into question. At the World Economic Forum in Davos this year, for instance, policy-makers and private sector actors puzzled with the question of whether the old consensus still holds or whether a new consensus is somehow emerging.1
One important measure to gauge whether a new policy consensus is emerging is the scope of the measures proposed to reform the international financial architecture (IFA). Indeed, since the crisis burst, there has been pressure from world leaders to intensify work on a complete overhaul of the institutional architecture of the global financial system – a sort of Bretton Woods II. In this connection, several international bodies, such as the Financial Stability Board (FSB), the International Monetary Fund (IMF), and the G20, have been involved in elaborating a series of measures to address the shortcomings brought to the surface by the sub-prime crisis.
This essay tackles the issue of the reform to the international financial regime by tracing the evolution of the policy consensus in the academic and practitioner community on the measures deemed necessary to ensure global financial stability. Although it is too early to draw firm conclusions from the current debate, this essay nonetheless argues that the crisis has challenged the intellectual assumptions on which the governance of the international financial system was built after the Asian crisis. While the post-Asia intellectual and policy consensus emphasized the importance of markets in crisis prevention and management, after the sub-prime crisis it seems that the faith in the role of markets has been seriously undermined in favor of an approach favoring market regulation. In sum, the moralizing turn of the late 1990s (Best 2003), which recognized the ultimate value of the markets in ensuring international financial stability, has not gone unscathed in the aftermath of the recent crisis, opening a window of opportunity for the evolution of the principles underlying the reform efforts.
In order to trace such an evolution, the essay reviews two recent books on the reforms to the IFA by Andre Walter and Daniel Tarullo, focusing on the intellectual paradigm that underlined the process of international financial reform. While Walter’s book is focused on the reforms that followed the 1997 Asian crisis, Tarullo concentrates on the current turmoil and on the lessons that can be drawn from it.
Looking within and comparing across the two books, the focus will be on the cooperative efforts to draw rules for the financial industry, such as the ones institutionalized into the Basel II accord. The accord, which was elaborated by the Basel Committee for Banking Supervision (BCBS) in the early 2000s as an update of the previous 1988 agreement, is the internationally agreed set of banking regulations that require banks to set aside capital to maintain their existing lending. Why is it relevant to analyze banking regulation to gauge whether a new consensus on the international regulatory set-up is emerging? Several aspects of Basel II make of it an important indicator of what is happening at the international level. To start with, in an era in which financial institutions have a global reach and the integration of world financial markets facilitates contagion, what banks do acquires crucial importance to the preservation of systemic stability. Furthermore, despite their non-binding status, the Basel standards are widely implemented among industrial and developing countries alike and are commonly regarded as a model for other areas of international financial regulation. Hence, an assessment of what is changing in the debate on banking regulation may be of help disclose the major changes that are taking place in other areas of financial regulation.
Before proceeding, some clarifications are in order. Using the comparison between the two books to analyze the differences between the reform debate in 1997-98 and the debate in 2007-08, this essay does not intend to suggest that there has been a complete shift away from previously dominant governing principles for the workings of the IFA. For instance, although the essay emphasizes the signs in favor of an approach based on regulation, the debate is far from being settled. On the one hand, there are some reservations about the transfer of regulatory responsibilities to the international level (Rodrik 2009). On the other hand, the pro-market mantra has not been silenced in spite of the policy failures evidenced by the crisis, as attested by the debate on the international financial press (Rajan 2009, Rappeport 2009).
Hence, what this essay attempts to illustrate by reviewing the two books is that we are assisting to a moment of ideational contestation unleashed by a crisis, when old ideas are challenged and new ideas are gaining ground (Blyth 2002). This does not indicate that we have already reached a point of paradigmatic shift leading to policy change in the international financial architecture. As Kuhn (1962) has noted in his explanation of the evolution of science, the trajectory of a given intellectual consensus cannot be solely derived from the contradictions of the old consensus with the observable reality. Hence, we cannot predict the path of ideational and institutional change that will follow the sub-prime crisis by simply pointing to the inadequacy of the old consensus in addressing the sources of the current turmoil. What we can do, however, is to critically evaluate the differences with the recent past and to identify the signals that constitute potential factors for institutional change at the international level.
The essay is organized as follows. The following section introduces the problems related to the design of a new international regulatory architecture. Section II and III review the two books by
bringing to the surface the tenets of the policy consensus that informed the international financial debate in the 1990s and by assessing what has changed in the consensus in the aftermath of the subprime crisis. In the last section, I build on the review of the two books to reflect on the scope and direction of change in the international financial architecture.
I. Reforming the International Financial Architecture
Political scientists have long recognized the importance of economic and financial crises as a condition that makes policy change more likely to take place (Blyth 2002; Gourevitch 1986; Hall 1993). Economists also tend to attribute significant value to crises as moments in which prevalent doctrine is re-assessed and the influence of their technical advice increases (Fischer 2004). As an economist put it, ‘when a new crisis hits, the previous generation of models is judged to have been inadequate’ (Rodrik 1998, 58). And indeed the sub-prime crisis was no exception. While governments have been busy in adopting emergency measures to prevent a historic financial meltdown, the debate on the medium- and long-term policies that need to be adopted to reshape the functioning of the international financial system had already begun. The debate on the reforms to the international financial architecture is not new to the dynamic of international cooperation. To mention just the two most recent predecessors of the current debate, would-be reformers were mobilized after the 1994 Mexican crisis and after the 1997 Asian crisis. Since then, the reforms adopted in the area of crisis prevention and crisis management attributed an increasingly important role to the private sector in ensuring international financial stability.2 In contrast, the role of governments and intergovernmental
organizations, such as the IMF, was downsized. The boom in the elaboration of international standards that materialized after the Asian crisis offers an explicit example of the logic that informed the actions of the reformers. In particular, the process of international financial standardization well illustrates the approach that came to inform the governance of the international financial system.
The rationale underlying the standardization process was that weak financial systems could undermine macroeconomic stability and market confidence. As the IMF put it in its website, ‘the financial crises of the late 1990s underscored the linkages between macroeconomic developments and financial system soundness.’3 In this connection, developing international
standards to guide national authorities’ economic conduct, in particular in the developing and middle-income countries, became one of the key policy measures of international financial cooperation. Bringing domestic financial sector regulation of emerging markets in line with international standards, so the argument went, would help to foster financial stability and better risk assessments.
One of the crucial aspects of the process of international standardization is the involvement of the private sector as both an enforcer of compliance with international standards (Simmons
2 About the transfer of regulatory authority to the private sector see, for instance, Claire A. Cutler, Virginia Haufler, and Tony Porter, eds., Private Authority and International Affairs (Albany: State University of New York Press, 1999). and Richard A. Higgott, Geoffrey R. D. Underhill, and A. Bieler, eds., Non-State Actors and Authority in the
Global System (London: Routledge, 2000).
2001) and a recipient of those standards (Moschella and Pellizzari 2007). Indeed, the success of international standardization was perceived as being critically dependent on private market participants’ response (Financial Stability Forum 2000; Mosley 2003). If market participants would have assessed countries’ performance against internationally recognized standards in their investment decisions, the threats to international financial stability would have been reduced. Furthermore, by endorsing international standards in their investment decisions, thereby pricing capital on the record of compliance with international standards, market participants would have helped enforce countries’ compliance. In the words of the former First IMF Deputy Managing Director Stanley Fischer (1999), ‘if the terms on which countries can borrow depend on how well they are doing in meeting the standards, we can be sure that countries will be encouraged to adopt the standards. If not, the standards effort will be far less successful than it deserves to be.’ In sum, the process of international standardization endorsed after the Asian crisis as a mechanism to govern an integrated global financial system was staked on the premise that market deserved pride of place in the governance of the system.
The sub-prime crisis, however, has demonstrated the ineffectiveness of the governance approach as conceived at the end of the 1990s. In particular, contrary to the expectations raised in the post-Asian environment, the crisis erupted in the domestic financial system of the United States and not in the financial market of an emerging market country. In other words, the crisis was the result of risky lending decisions undertaken by the private sector in the industrialized world rather than the result of poor-developed domestic financial markets. As a result of the crisis, an intellectual rethink is somehow emerging. That is to say, existing governance principles are questioned and new policy ideas are gaining increasing attention. In particular, whereas it was believed that market actors could look after themselves and contribute to international financial stability, the alternative view is that markets require strong regulatory mechanisms to function effectively.4 As a result, whereas after 1997 the governance of the international financial system
revolved around the principles of supervision and markets’ self-regulation,5 the initial policy
responses to the subprime crisis reveal a growing consensus in favor of markets regulation – at least on paper.
The two books reviewed in this essay offer an extraordinary opportunity to reflect on the governance of the international system and, in particular, on its rationale, its effectiveness and its potential reform. Indeed, Walter’s book focuses on the ‘regulatory reform project’ that followed the Asian crisis while Tarullo tackles the issue of what to do to reform the architecture in light of the sub-prime crisis. Setting aside their focus on international financial regulation, the two books also share an interest for some other issues. To start with, both books ask about the role that financial crises play in triggering policy change at the international level. Hence, both books induce the reader to reflect on the conditions under which a crisis actually translates into political action. Still, the two books engage with political problems such as the influence of the G7/8 on internationally-negotiated policies, the role of the international financial institutions (IFIs) in
4 The Director of the US National Economic Council Larry Summers, for instance, has been reported saying that the view that the markets are inherently self-stabilizing had been ‘dealt a fatal blow’. In Edward Luce and Chrystian Freeland, "Summers Backs State Action," Financial Time, March 8 2009.
5 On the transformation in the ‘institutions’ governing globalized finance see, for instance, Tony Porter,
diffusing these policies, and the difficulties in implementing international rules at the domestic level.
In what follows, I will review the two books by analyzing each author’s argument and policy recommendations for the governance of the international financial system. In particular, by comparing the two books, I will try to gauge the extent to which change is emerging in the economic ideas that formed the policy consensus upon which the governance of the system was built in late 1990s.
II. Governing Finance: The Politics of International Financial Standards
Governing Finance is an interesting book about the origins and the implications of what the
author defines as the ‘regulatory project’, that is, the set of reforms adopted after the 1997 Asian crisis to minimize the risks of global financial integration. Specifically, Walter analyses the pattern of compliance with several international financial standards in a group of four East Asian countries, including Indonesia, Thailand, Malaysia and Korea. One of the most important contributions of the book lies in the author’s attempt to move beyond the analysis of ‘formal’ compliance with international financial standards in order to assess their actual implementation. Before moving on to investigating the content of the book, it is first necessary to clarify the contours of the ‘regulatory project’ whose emergence and evolution Walter critically traces in his book. As already noted, the regulatory project refers to the international policies pursued after 1997-98 in the area of financial regulation. The aim of the project was that of transforming domestic financial governance in emerging market countries. In particular, the regulatory project was based on the notion that the diffusion of international financial standards, modeled upon those of the Western countries, would be of help in ensuring domestic and international financial stability. The adoption of internationally recognized standards in the area of capital requirements, accounting and corporate rules, among others, would have diminished the probability of a crisis in an emerging country with the attendant global contagion.
The international standard project is thereby closely linked with the events of the Asian crisis when domestic financial weaknesses contributed to – and amplified – the effects of what started as a typical currency crisis.6 However, Walter clearly argues that the reforms adopted in the
aftermath of the East Asian crisis cannot be considered as the automatic response to the event ‘crisis’. Rather, as the author put it, ‘the focus on domestic regulatory failures reflected …. a growing policy consensus about the basic principles of economic regulation’ (pp. 18-19). This consensus revolved around the recognition of the role that international standards could play in achieving the goal of global financial stability. It would have been up to domestic technocratic agencies and to market actors to supervise and enforce compliance with the international standards at the domestic level.
By pointing to the role played by ‘principles’ and ‘policy consensus’ in shaping the reforms to the international financial architecture, Walter implicitly relies on the assumption that crises have
6 A currency crisis occurs when the incompatibility between domestic macroeconomic policies and exchange rate policy drive investors to think a currency might be devalued thereby making them unwilling to hold financial assets denominated in that currency.
to be interpreted in order to stimulate a specific policy response. In other words, in line with the constructivist political economy literature, the implicit assumption here is that crises do not speak for themselves but need to be interpreted by human agency (Hay 2001; Widmaier et al. 2007). The recourse to ideas to explain the response to the Asian crisis, however, stands in contradiction with the overall theoretical framework of the book that, as it is explained below, relies on rational theories to explain the pattern of domestic compliance with international standards.
To do justice to the book, however, Walter does not make a case to prove the autonomous role that ideas played in shaping the 1997-98 regulatory project. Rather, despite the recognition of the role that the 1990s predominant consensus played, the author argues that the consensus was ultimately little more than the reflection of the ideas held by the most powerful countries. As Walter put it, ‘the envisaged transformation [of the domestic financial systems in emerging market countries] was consistent with a new consensus in Western policy making and academic circles’ (p. 1, 8). Hence, what mostly shaped the contours of the reforms at the international level was the light-touch regulatory model, which is typical of the UK and of the United States. Furthermore, according to the author, the diffusion of the Anglo-Saxon model was supported by the activity of the international financial institutions (p. 19).
After having assessed the consensus that emerged after the outbreak of the Asian crisis and the policies that derived from it, Walter offers a straightforward argument about the appropriateness of the regulatory project as a foil for international financial cooperation. As the author concisely put it, ‘this approach has serious flaws’ (p. 2). On the one hand, the process through which international financial standards are produced is politicized and controlled by powerful actors. On the other hand, internationally-elaborated standards do not properly fit with countries’ different economic circumstances. This, in turn, generates problems of compliance. In particular, Walter reveals the existence of mock compliance – whereas national authorities pretend to implement international standards because the implementation costs for politically influential domestic groups are too high. ‘Government, bureaucratic and private sector actors may all have incentives visibly to signal compliance when in fact their underlying behavior is inconsistent with compliance’ (p. 32).
The analysis of domestic compliance with international financial standards in Indonesia, Thailand, Malaysia and Korea is the core of the book and an important contribution to the debate on convergence/divergence under conditions of globalization. Contrary to the literature that emphasizes the role of markets as a mechanism to enforce compliance in domestic settings (Ho 2002; Simmons 2001), Walter focuses on domestic factors. ‘Once governments had made formal political commitments to compliance, domestic politics took over’ (p. 171). In particular, building on a rationalist framework, the author points to the incentives faced by domestic actors to account for different degrees of compliance with international standards in the four case-studies. For instance, when the implementation costs are too high for influential private sector groups, governments face serious constraint in complying with international rules. Likewise, the more the implementation costs fall on the public rather than on the private sector, the more likely their adoption will be at the domestic level. Hence, whereas standards imposing transparency are more likely to be adopted, the standards dealing with prudential regulations for banks or
corporate rules for firms face the highest constraints because of the implementation costs that domestic firms face.
The study of domestic compliance with international standards is not an end in itself but an instrument to assess the viability of the regulatory project and, in particular, to assess its capacity in bringing about international convergence of regulatory practices. Building on the findings of his book, which reveal a poor record of domestic compliance, Walter thereby concludes that the proponents of the international regulatory project have underestimated the hurdles to the envisaged process of international convergence (p. 180).
Expanding on this conclusion, Governing Finance contains a set of implicit and explicit policy recommendations for the design of the international financial architecture. To start with, by arguing that domestic political factors largely drive compliance outcomes, Walter suggests that the influence of external pressures, such as the ones exerted by the IFIs, is less than conventionally assumed (p. 41). Hence, in line with much of the post-Asia commentaries, it follows that the role of the IMF should be streamlined (Eichengreen 1999; Goldstein 1999). This position is reinforced by Walter’s empirical analysis where the skepticism for the role of the IMF in contributing to international convergence clearly emerges. Furthermore, the author repeatedly emphasizes that the IFIs have no leverage on the private sector and this means that the IFIs cannot induce market actors to use countries’ compliance with international standards as a criterion for their investment decisions. For instance, Walter points out that ‘private sector actors have felt that ROSC publications have poor coverage, are too opaque, too infrequent, and rarely updated’ (p. 12) – where ROSC stands for the reports on the observance of standards and codes, that is, the World Bank-IMF joint exercise in detecting member countries’ financial vulnerabilities. ‘Overall,’ Walter thereby concludes, ‘the ability of the IFIs to promote convergence upon the standards regime must be in some doubt’ (pp. 12-14).
Another important policy recommendation concerns the future of international financial standards. Although Walter is skeptical about the potential of the regulatory project in bringing about international convergence and thereby reducing systemic financial instability, the author’s conclusion is not that of scrapping the project but to loosen it. ‘Effective regulation is certainly possible while diverging from some core standards of the current global financial architecture’ (p.179). In sum, decoupling domestic rules from international rules is appropriate and does not mean more instability. What the system needs is a more country-tailored approach. Effective financial regulation ‘is likely to depend on the level of development, sophistication, and internationalization of the economy, as well as on the nature of corporate ownership and financing’ (p.179).
In conclusion, it is worth reflecting on the achievements of the regulatory project, that is, on its record in ensuring international financial stability. As already pointed out, the regulatory project was staked on the assumption that the main risk to the global economy was likely to materialize in the domestic financial system of an emerging market country. Hence, the reforms to the IFA followed the principle that emerging market countries had to reform their domestic financial systems to bring them in line with those of the advanced countries. In drafting international banking regulation, for instance, as Walter clearly explains ‘the BCBS [the Basel Committee on Banking Supervision] and other international standard setters drew heavily upon institutional
designs and practices in the major developed countries, especially those with the most sophisticated financial markets’ (p.22). In other words, it was ‘implicitly assumed that [Western] regulatory systems had been operating efficiently’ (p. 24). Nevertheless, the sub-prime crisis proved these assumptions wrong. The Western world expected the crisis to erupt in an emerging market country. In fact, it did erupt in the most sophisticated financial market in the world: the United States.
III. Banking on Basel: Back to the drawing board
Tarullo somehow starts where Walter leaves off. Indeed, Banking on Basel asks about the evolution of a specific category of international financial standards that had been part of the regulatory project. Specifically, Tarullo concentrates on banks’ prudential and capital requirements as set forth in the Basel accord.
The Basel accord, initially negotiated in 1988 and profoundly revised in 2004, pursues two objectives. On the one hand, the accord aims at enhancing the safety and soundness of internationally active banks. On the other hand, it is meant to promote competitive equality among banks from different countries. In doing that, the Basel agreement set the standards governing the capital adequacy of internationally active banks. That is to say, the agreement specifies the formulas and mechanisms that banks should follow in setting aside capital as a prudential measure against potential credit and operating risks. The Basel accord has a three-pillar structure. Whereas three-pillar 1 set the standards for banks to follow, three-pillar 2 sets forth the prescriptions that domestic supervisors are expected to follow to ascertain whether banks risk management practices are adequate for capital calculation. Finally, pillar 3 points to market discipline as a further mechanism through which banks will adopt adequate capital requirements. In assessing the effectiveness of Basel II standards, Tarullo builds on the assumption that Basel II can be regarded as a ‘milestone’ of international financial cooperation at least in an important respect. Indeed, ‘the accord brought about a major change in the basic method of making regulation … by completely overhauling the minimum capital requirements that have become central to prudential supervision.’ Indeed, one of the major changes brought about by Basel II is the introduction of a risk-sensitive approach – the so-called advanced internal risk-based (IRB) approach. Specifically, Basel II has aligned regulatory capital requirements to the underlying risks that banks really face. Rather than setting aside a minimum capital requirement as was the case under Basel I, under Basel II, capital requirements are a function of the different risk profile of banks’ portfolios.7 In this connection, the 2004 accord allows banks to use their own internal
measures and models to determine the riskiness of their portfolios.8 The higher the risk the
higher the capital requirements, where the level of risk is decided by the banks themselves. As has already noted, the sub-prime crisis has seriously questioned the adequacy of the rules embodied in Basel II. Tarullo, for instance, clearly highlights the link between the sub-prime crisis and the Basel II standards. ‘Key features of Basel II include reliance on the internal risk models of large banks to determine minimum capital requirements, the use of external
credit-7 In other words, Basel II is a more flexible agreement than Basel I was because it allows banks to adjust their capital reserves to the types of assets in their portfolio.
rating agencies to help set capital requirements for most banks, and an overall reduction in the risk weighting assigned to residential mortgage.’ Interestingly, however, the crisis has vividly demonstrated the weaknesses of all those features by calling into question ‘the reliability of risk modeling, the usefulness of external agencies rating, and the benign view of residential mortgage riskiness’ (p. 14). Indeed, the crisis mainly originated because of excessive leverage of the financial industry in the industrialized countries, that is, in those countries where the application of the Basel standards was supposed to provide an effective shield against such a type of crises. Although well-capitalized according to the Basel standards, several internationally active banks proved vulnerable to the volatility of the risky sub-prime assets that they had accumulated in their balance and off-balance sheet. In sum, the crisis provided a graphic demonstration of the weaknesses in the supervisory system where banks are largely left to regulate themselves. As a result, banking regulation is one of the most contentious issues in the debate sparked by the sub-prime crisis. Indeed, it has become increasingly common to hear that ‘all the pillars of Basel II have already failed even before being implemented’ (Roubini 2009). In light of these shortcomings, Tarullo thereby engages with the task of assessing the usefulness and the effectiveness of the ‘regulatory paradigm’ represented by Basel II. His conclusion is a moderate but deep critique. In the words of the author, ‘Basel II’s detailed rules for capital regulation are not an appropriate basis for an international arrangement among banking supervisors’ (p. 5). Tarullo’s conclusion is based on a series of criticisms that seem to question some of the key features of the policy consensus that prevailed in the aftermath of the Asian crisis.
To start with, Tarullo critically regards the view according to which internationally recognized standards, including the Basel standards, can largely be applicable to different domestic systems. As the author emphasizes, the standard’s universal character is more often a liability rather than an asset in the process of domestic implementation. On the one hand, implementing international standards may prove difficult and costly because of the lack of administrative capacity or because of supervisory limitations. For instance, the sophistication of the IRB method made its implementation all the more difficult. On the other hand, although the Basel standards may be conceptually superior, they may also be fundamentally different from existing domestic rules. Hence, ‘from the standpoint of one country … the key question is whether the gains from having other countries subscribe to Basel II rules will offset the losses from following rules different from those that would have been generated in a purely domestic process’ (p. 6). In sum, by stressing the ongoing importance of domestic factors, Tarullo highlights the deficiencies of Basel II in bringing about international regulatory convergence.
The second and important criticisms raised at Basel II touches on the principle of self-regulation. Indeed, Tarullo argues that the IRB approach attributes to big banks a too large room of maneuver that they can use to manipulate capital levels (p. 172). Furthermore, Tarullo argues that the IRB approach is too complicated and demanding for domestic supervisors. In particular, giving banks the possibility to use internal model to assess risks means demanding from domestic supervisors an expertise that only commercial banks fully possess (p.168). Not surprisingly, the introduction of the IRB approach has been forcefully sponsored by the private sector. Indeed, after Basel I had been adopted, ‘widespread diffatisfaction among large banks … sent the committee back to the drawing board. Attention was redirected toward an approach that relied on banks’ own internally generated credit ratings for specific exposures’ (p. 9). Building
on these observations, Tarullo thereby concludes that ‘the potential benefits of the A-IRB approach are likely outweighed by its risks and shortcomings’ (p. 10).
In light of these shortcomings forcefully brought to the surface by the subprime crisis, ‘which revealed massive failures of risk management by financial institutions and of supervision by government authorities’ (p. 4), Tarullo lays down a set of policy recommendations to reform the international regulatory set-up. These policy recommendations depart from the policy consensus nurtured in the aftermath of the Asian crisis in some important respects. Specifically, Tarullo suggests reducing the scope of private sector self-regulation, placing less faith in market discipline and enlarging the scope of financial regulation along that of supervision.
The first policy suggestion is that of reducing the reliance on banks’ internal risk management models and practices. In other words, Tarullo suggests reducing the applicability of the IRB approach. Although Tarullo does not suggest a fully-fledged rejection, he nonetheless supports the adoption of an approach similar to that of standardization that characterized the Basel I accord. Indeed, under Basel I, all banks were subject to common minimum capital requirements independent from the riskiness of their portfolios. ‘Its very simplicity makes [the standardized approach] deserving of consideration as one element of an international capital regime’ (p. 228). This recommendation bears important implications for the overall framework of financial regulation as conceived thus far. In this connection, limiting the use of the IRB approach means limiting the room of maneuver of the private sector and thereby limiting the applicability of the principle of self-regulation. Indeed, Tarullo argues that the responsibility for the soundness of the financial sector, that thus far has primarily fallen on the private sector, should be clearly attributed to domestic and international regulators. In the clearest formulation of his preference for stricter regulation, Tarullo calls for rebalancing the relative weight of the three pillars making up the Basel II structure. Specifically, Tarullo makes the case for diminishing the scope of pillar I and expanding the one of pillar II. In his words, ‘in place of the IRB rules would be a simple pillar 1 requirement for some form of risk-based capital requirement applicable to systematically important banks and a set of pillar 2 principles addressing both bank risk-management and supervisory oversight of bank capital’ (p.273).
The rethink on the role of the private sector in the governance of the international financial system is then evident in Tarullo’s position on market discipline, that is, on pillar 3 of the Basel agreement. ‘The intuitive appeal of direct market discipline is undeniable. As the centerpiece of bank regulation, however, market discipline will almost surely fall short.’ Indeed, according to the author, the presence of factors such as ‘asymmetric information, high leverage ratios, financial interrelationships, and government deposit insurance’ signal that market failures remain significant and thereby markets require regulation to function smoothly (p. 242). Furthermore, market discipline may be limited ‘if investors do not have access to information giving early signs of problems, or if the noise from broader economic developments drowns out the bank-specific signal contained in a bond price’ (p. 243).
After having made the argument against the principle of self-regulation and market discipline as mechanisms to ensure domestic and international financial stability, Tarullo clarifies his position in favor of a shift away from supervision and towards regulation. Specifically, he argues that
prudential supervision, such as the one embedded in the Basel II accord, is no longer sufficient to prevent crises and instability. ‘Capital regulation cannot bear as much of the weight of prudential regulation as has been placed upon it’ (p. 11). The implication is that expanding the perimeter of regulation is required for both risk management practices and financial products. In other words, the author proposes an expansion of bank regulation to make up for ‘the tardiness of adjustment by financial regulators to far-reaching changes in financial markets’ (p.14). In arguing for regulation, Tarullo goes as far as suggesting the transformation of the Basel Committee in an international supervisory agency, although he admits the political difficulties that his proposal would face (p. 251-55).
IV. A new regulatory paradigm?
Ten years after the East Asian crisis and the attendant debate on the reform to the international financial architecture, the international community is again in search of a ‘grand bargain’ (Goldstein 2009) to address the inadequacies of the existing regulatory set-up. While it is early to speculate on the full implications of the reforms that will be enacted in response to the subprime crisis, a number of initiatives seem to suggest that several of the principles that have marked the reforms of the IFA in the 1990s have been challenged. This thereby raises the question of whether the system is shifting towards a different form of governance. In particular, a number of reform proposals seem to indicate that the governance of the system will be more inclined towards regulation in the near-term future than it has been thus far.
The debate on financial regulation that is taking place within the European Union is particularly relevant here. Indeed, the EU is calling for a regulatory framework that covers ‘all financial markets, products and participants’ (Bryant 2009) first and foremost within the Union but also at the international level. For instance, the EU institutions have developed a number of proposals to centralize supervision of financial firms at the EU level (de Laroisiere 2009) and to strengthen the role of international bodies, such as the IMF, in presiding over systemic stability (Hall and Eaglesham 2008). Still, several EU member countries have called for tighter controls and regulation on hedge funds, tax havens and credit rating agencies (Hall and Mackintosh 2009).9 In
short, the EU is supporting a series of reforms based on the two guiding principles: expanding regulation and centralizing governance (Posner 2009). Emphasizing the now prevalent mood in Europe, the French President Nicolas Sarkozy even concluded that ‘a page has been turned’ on an era of post-war ‘Anglo- Saxon’ capitalism (as reported in Parker, et al. 2009)
Interestingly, then, this view appears on the rise also outside of the EU. Several analysts, for instance, have pointed out that the Anglo-Saxon model of capitalism has been seriously questioned (Buiter 2008). According to Nouriel Rubini (2009), then, the three pillars of self-regulation, market discipline, and internal risk management models, which characterized the financial supervisory system of the past decade, have all failed. Stressing the irrationality of markets, two respected economists, George Akerlof and Robert Shiller (2009), have recently
9 The EU also approved a new regulation that will raise standards for the issuance of credit ratings used in the Community. More information is available at the EU website http://europa.eu/rapid/pressReleasesAction.do? reference=IP/09/629&format=HTML&aged=0&language=EN&guiLanguage=en
argued to rebuild the orthodox economic doctrine, keeping in due consideration what Keynes used to define ‘animal spirits.’ That is to say, markets are perceived as destabilizing forces that must be contained and not as agents of financial stability as the intellectual parading of the late 1990s have forcefully argued. In this connection, the G20 leaders agreed to ‘extend regulation and oversight to all systemically important financial institutions, instruments and markets’ (G20 2009a). This proposal derived from the recognition that ‘reckless and irresponsible risk taking by banks and other financial institutions’, along with failures of regulation and supervision, ‘created dangerous financial fragilities that contributed significantly to the current crisis’ (G20 2009b). Still, the signs of pending change are also evident in the United States where the Obama administration pledged to reform rules on financial markets and institutions with the Treasury Secretary Tim Geithner calling for ‘new rules of the game’ to regulate the domestic financial system (Braithwaite and Guerrera 2009).
In short, there are signs of a growing rethink of the intellectual consensus around which the reforms of the post-Asia crisis were pursued. However, this review essay has not suggested that we are in front of a fully-fledged regulatory shift – at least for now. That is to say, we should not mistaken the policies adopted to contain a crisis – often in the haste to stabilize financial markets – as permanent deviations from well-established positions. Indeed, it is hard to claim that the case for reform has definitely won. Although policy makers of all stripes and countries, spurred by taxpayers’ anger, pledged to re-regulate the financial industry and pressed to limit bankers’ bonuses, few policies have actually been delivered, raising the question of whether the political resolve to regulate will be maintained in the coming months.
Hence, analyzing the argument and the policy recommendations contained in Walter’s and Tarullo’s book, this essay has more simply attempted to bring to the surface the distinctive traits of the intellectual consensus that informed the debate on the reform of the IFA at the end of the 1990s and the potential for change in the aftermath of the subprime crisis. Although it is not yet clear whether will see a new regulatory regime in the international system, the argument is that the politics of financial reform has already begun as attested by the fact that the old consensus has been called into question and new ideas are gaining resonance. The outcome of this battle, however, is far from settled, especially in light of the growing industry pressures against the new regulatory wave. Hence, in order to ascertain whether the old paradigm will be replaced by a new one we should wait to see whether the emerging principles of the regulatory consensus will become widely shared among a variety of actors, both states and non state-actors, whose activities contribute to the persistence of a particular architecture.
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