Financial Post Articles
(Ed. note) Henry Kaufman is president of Henry Kaufman, the Wall Street investment fund.
Loose co-operation not enough to ensure a safe system
Regulating the global marketplace
Leaders of the Group of Seven industrial nations are spearheading an initiative to oversee global financial institutions and markets. This involves greater information sharing and harmonizing some supervisory practices.
The rationale behind the initiative, launched at the Denver Economic Summit last month, is that a better information flow will enable regulatory authorities to avert future shocks to the financial system such as those that followed the Mexican peso crisis of 1994-95. This modest step, while perhaps in the right direction, is neither novel nor remotely adequate to the task of assuring a safe and sound global financial system.
Transformation of global financial markets has proceeded at a tremendous pace; meanwhile the infrastructure for supervising and regulating financial institutions and markets has remained national, lagging badly behind marketplace developments. The supervisory apparatus has yet to come to grips with the main driving forces of the new world of global finance: securitization, institutional change and consolidation, the changing nature of asset management and the growth of derivatives.
Securitization means assets that used to be held to maturity on the balance sheets of traditional financial institutions, mainly banks and insurance companies, are now packaged and sold in an open market. It stands to reason the greater the proportion of financial assets that are marketable, the greater the potential for volatile price movements and the probability large losses may threaten the viability of some market participants.
Institutional change and consolidation have reduced the number of market participants capable of having a large influence on movements in asset prices. Thus, unlike the textbook world of perfect competition, the decisions and trading activities of a progressively smaller number of participants are determining the evolution of asset prices.
Finally, the rapid growth and increasing complexity of financial derivatives -- futures, swaps, options, and securities created to embed various combinations of all of them -- have multiplied the potential for a shock to careen through the financial system. It has increased the capacity of market participants to take speculative positions in financial markets.
Concerns about potential financial shocks appear distant and somewhat hypothetical. After all, we are living in euphoric financial times. However, the expansive global marketplace will be severely tested when business activity picks up outside the U.S., liquidity shrinks and credit conditions tighten. At some point, the marketplace will be faced with heightened risks and the need for improved supervisory capabilities will be apparent.
We must move more speedily to establish a formal institution with genuine authority over global financial institutions and markets. This is the only way to lessen the danger of a market meltdown the next time conditions turn less favorable. Just as important, it is essential for achieving competitive equity among market participants.
Instead of the G7's modest proposal for loose co-operation and better information exchanges, I recommend a more ambitious initiative: a Board of Overseers of leading international institutions and markets with the mandate to take on the whole range of difficult issues raised by the globalization of finance.
The board would set minimum capital requirements for all major financial institutions and establish uniform trading, reporting and disclosure standards for open credit markets.
My recommendation will be vigorously opposed by some who would perceive a loss of national sovereignty. To these, I would point out the globalization of finance has already eroded some pristine concept of national sovereignty.
It may be impractical to expect legislative bodies to agree to such a fundamental innovation except after a crisis. But it is exactly such a systemic catastrophe that we must avert. In the meantime, we ought to recognize the global financial system is an incubator of risk. Markets always tend to gravitate to the area where terms are the most liberal and constraints are the lightest.
The longer the present exuberance in financial markets goes on, the stronger the case for instituting a rigorous multinational system of financial supervision.
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