Reregulation and fragmentation in international financial governance.(Report)

Every global financial crisis generates new regulatory responses. What kinds of responses are emerging so far from the crisis that began in 2007? How are these responses similar to or different from those that followed the last major crisis of 1997-1998? Arguably this crisis marks an important turning point in the governance of international financial markets. Not only is there a significant reregulation of international financial markets by the leading Western governments, but the crisis is also unleashing centrifugal pressures that may lead toward a more decentralized and fragmented form of international financial governance over the medium term.

The G7's Push for Reregulation

The world is clearly changing when top international bankers announce the kind of intellectual conversion that the chief executive of Deutsche Bank, Joseph Ackerman, did in March 2008. "I no longer believe in the market's self-healing power," he announced. A few weeks later it was the turn of the influential columnist of the Financial Times of London Martin Wolf to declare that the rescue of Bear Stearns marked the day when "the dream of global free-market capitalism died." (1) By September, political leaders such as French president Nicolas Sarkozy were echoing this message. "Self-regulation is finished," he proclaimed, "Laissez faire is finished. The all-powerful market that is always right is finished." (2) These dramatic statements highlight the seriousness of the current global financial crisis. But they also reveal how different its political implications are from the last global financial meltdown a decade ago.

In 1997-1998, global financial markets were severely shaken by a series of crises emanating from developing countries. Policymakers in the G7 countries largely attributed those crises to mistakes in government policy. The afflicted countries had borrowed excessively and had to be encouraged to exercise greater discipline. Their financial regulatory and supervisory practices were deemed to be inadequate and to require improvement to meet international standards, particularly Anglo-American standards. G7 officials even blamed themselves for encouraging excessive risk taking in international financial markets through their backing of ever larger IMF rescue packages. At the core of these views was the belief that global financial markets themselves were not to blame for the crises. This trust in the markets was also reflected in G7 decisions in the subsequent decade to assign an increasing range of regulatory functions to private financial actors such as banks, credit rating agencies, and accountants. (3)

As the preceding quotations make clear, the political dynamics associated with the current crisis could not be more different within the G7 countries. There is a strong consensus that the same market actors who were previously assigned important regulatory roles have been key culprits in triggering the current crisis. Private financial institutions and markets have been particularly criticized for their failure to recognize the risks involved in various market innovations associated with new models of securitization. Sub-prime mortgage loans were transformed into securities, which were then bundled and sliced up into tradable portfolios with distinct risk profiles. As credit risk was transferred and traded to parties far removed from the original source, its quality became more obscure and was consistently under-priced by credit rating agencies and other institutions. Once the crisis broke out, the far-flung diffusion of subprime mortgages also intensified the erosion of confidence because of widespread uncertainties about who actually held these products and what their levels of exposure were.

Particularly opaque were the over-the-counter (OTC) derivative markets, including the enormous market for credit default swaps. Here private actors (predominantly highly leveraged hedge funds) engaged in private bilateral deals without a formal clearinghouse or exchange that could minimize counterparty risk and force margin requirements for all contracts. Making matters worse, banks had created unregulated and highly leveraged "off balance sheet" structured investment vehicles to participate in these new markets. In addition, other institutions involved in securities markets--including investment banks, bond insurers, hedge funds--had become more systemically important but were not covered by rules of prudential risk management.

From the standpoint of G7 policymakers, the crisis has highlighted clearly the need to bring these private financial markets and institutions under much tighter regulation. Even those who have been less inclined to blame private markets have been forced to recognize that the enormous bailouts of financial institutions have made the case for tighter regulation politically uncontestable. Taxpayers simply would not accept the allocation of such large sums of public money without a guarantee that financial institutions will be regulated more tightly.