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Regulating the Banks: Next Steps

By Paolo Savona, professor emeritus, geopolitical economy,
and economic adviser, Associazione Guido Carli

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While the worst of the global economic crisis may be over, has it left regulators overly nervous and too keen to constrain?

The world economy has begun to recover, but the lingering effects of the crisis are still with us in the form of growing unemployment and mounting bad debts on banks’ books, which heighten the markets’ perception of risk more than real risk itself.

Having made unconventional use of available monetary and fiscal policy tools, authorities now insist on the need for an exit strategy, a way out of the excesses of liquidity and the budget deficits that have been created. The revision of financial regulation is also proceeding, with a view to preventing the recurrence of grave episodes of mismanaged savings, circumvention of rules regarding tax havens, abusive conduct by managers and excessive leverage of households and savings intermediaries.

In this area, the United States and many other countries have proceeded on their own or – considering the modest scale of the decisions actually taken – have at least given the impression of going it alone. However, the G8 summit in L’Aquila in July 2009 called for future actions to be guided by 12 principles developed by the Organisation for Economic Co-operation and Development (OECD) in cooperation with Italy’s Ministry for the Economy and Finance, which has rechristened them the Global Legal Standard.

The key points of this new financial governance – encapsulated in the terms transparency, integrity and ethical conduct – have been entrusted to the G20 at their summit in Pittsburgh. The G20 will verify their incorporation into the decisions taken at the national level and, if the extent of their application is still insufficient to govern world financial trading, will press for their adoption as global standards.

On transparency, the advances achieved are more visible in the behaviour of authorities and markets than in new regulations. Up to now, the regulatory void has been filled mainly by stress-testing banks in the US, whose lead has been followed by a few other countries, and the greater alertness of authorities, banks (taken to mean institutions that manage savings and credit in every form), firms and savers.

This is so partly because the largest institutions in the sector are using every means at their disposal to resist new and more incisive regulation, since they hope to run their own business with their hands free of constraint – just what led to the present situation.

This reaction may be understandable on the part of those few that take risks with their own funds, but it is not on the part of the vast majority that manage people’s savings.

The aversion to new regulations extends even to over-the-counter (OTC) derivatives. Some still refuse to see that in certain forms, OTC derivatives are substitutes for money demanded for speculative purposes and are more likely to engender risks rather than to properly manage risks or distribute them among market participants with different risk appetites.

These aspects are now cloaked by a veil that, with the decline in activity in this segment of the financial market, obscures its desire to resume business as before – which is already happening in the form of financial parthenogenesis (i.e., finance that creates itself), not as an ancillary activity to real growth.

Under the heading of integrity – with securities maintaining the promises inscribed in them, from the rate of return to the value of the principal – progress is nearly nil. Economic history shows that financial crises arising from speculation are the norm for market economies, not the exception. They can be prevented not by law but only by appropriate economic policy management adopting the objective of financial stability.

Financial stability suggests the protection of savers and requires monetary and fiscal policy action guided by utility functions. This is quite different from the current division of tasks, whereby monetary policy’s mandate consists of curbing inflation and, in the case of some central banks, fostering economic growth. It is up to fiscal policy to ensure growth, fair income distribution and employment.

As to ethical conduct, if this expression means conduct consistent with a professional code of ethics or accountability to stakeholders, such behaviour can never be imposed by law, but only by the control exercised, broadly speaking, by the community or by public opinion and, in a strict sense, by the effective owners (whether shareholders or not).

Ethical conduct can be attained when operators assimilate the values of professional correctness and an awareness of the duties of membership in a civil society. What the rules must do is avoid fostering the belief on the part of savers that the state will protect them: governmental protection is possible only on a limited scale and for specific asset classes, such as bank deposits and government securities.

The assumption of greater responsibility must not be limited to private managers and public overseers, but must also involve savers, whose duty it is to improve their financial literacy. For these reasons, it would be useful if the Pittsburgh Summit transformed the commitment to foster ethics in finance to raise the level of financial education and culture of the planet’s inhabitants.

The G8’s L’Aquila Summit did not address the issue of the consistency between the growth of sovereign wealth funds and the quest for efficiency characteristic of the free market. Nor did it discuss the expansion of Islamic finance. The latter is gaining ground (and consensus), even in major financial centres, presenting itself as more ethical and higher in integrity than western finance, despite its substantial deficit of transparency and obscure expression of integrity.

The framework of the Global Legal Standard cannot be completed today without considering these two aspects of the global financial problem. By the same token, it seems contradictory to seek new financial governance without addressing the problem of the role of an international reserve currency, performed by the dollar, in the presence of an enormous US external account deficit, and in the absence of a common exchange rate regime for all the countries that participate in world trade.

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