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IFI governance

Background

Future of the Global Financial System

Panel debate chaired by Martin Wolf, Istanbul, 4 October 2009

5 October 2009

Raghuram Rajan, Professor, Graduate School of Business, University of Chicago

Three or four enormous crashes in industrialised countreis in recent years: dot-com; savings and loan etc. Question is whether excessive risk taking is intrinsic to finance. Citicorp is filled with the smartest people on earth yet has come cloase to collapse several times in recent decades. Can’t continue with business as usual – must reform whole system; think more deeply than incremental reform; e.g. capital adequacy requirements. Efficient markets is wrong if we think of it as meaning the market will reflect fundamentals – Keynes identified the problem; even if you think the market is wrong, no one has deep enough pockets to force it back to reality. Regulations were wrong, but also other problems including lack of enforcement due to lack of faith in the regulators vis-a-vis the market. Need much cleverer regulation, not just more regulation.

Lorenzo Bini Smaghi, Member of Executive Board, European Central Bank

Why did it happen? All agents were focussed on the short term – banks, regulators, central bankers, politicians. Why did agents behave in short term way? SOme parts of the world, particularly the advanced world are not accepting the implications of globalisation – that the advanced world will have to grow less to allow the rest of the world to grow more. SOme parts of the advanced world have tried to continue with rapid growth through borrowing. Globalisation has led to scarcity of resources – for example in some parts of the world the price of gasoline doesn’t reflect this. Will require parts of the advanced world to reorganise itself, including its social fabric to allow it to grow less. Otherwise incentives for short-termism will still be there – the temptation to borrow in order to keep growing.

Shengman Zhang, Chairman Asia Pacific, Citigroup Inc.

We don’t yet have the whole picture about what went wrong – dangerous to rush to conclusion. Need to rebalance a lot things – market and regulators; financial sector and real economy; national regulation and international oversight. Need to make finance work better; but shouldn’t rush into ‘fundamental reform’.

Lorenzo Bini Smaghi, Member of Executive Board, European Central Bank

Need institutions who are able to look beyond the electoral short term – like central banks have been given independence; should be strengthened. The same should be true for financial supervision. Should be more independent and less capturable by industry, households etc. Should have a mandate for stability, but also avoid competition between financial centres. Basle 2 allowed this discretion, but is wasn’t used, because financial regulators were captured in some countries. Supervisors should be monitored themselves. IMF has surveillance over central banks etc but not over financial regulators – should have article four consultations on financial regulation. Only way to help bring regulation closer together and avoid competition. Is this a crisis of democracy?

Shengman Zhang, Chairman Asia Pacific, Citigroup Inc.

Short term policy imperatives are (a)Need to get the economy going again. (b) Need smarter regulation in place and practised. (c) Banks need to learn to do better: on risk and reward; on transparency; on implications of their behaviour for society.

Henrique Meirelles, Governor, Central Bank of Brazil

Can’t see the conditions to create a global regulator. Taxpayers will ultimately be responsible for national insitutions, regardless of where it lends money – regulators have to take this into account. They make profits from this; should therefore assess risk properly. Global guidelines, including moral suasion can work – G20, IMF can play a role. But implementation will be on a national basis. In Brazil, national regulators don’t allow overseas risks; they are not global institutions. There is a basic problem with the notion that people can take risks that they don’t understand – applies to banks, and by implications, regulators. If we were to have global systems, global institutions would have to be able to analyse global risks. So in the case of UK banks investing in securised assets based on AMerican mortages; how can they understand the risks? National authorities should not allow this to happen. Cannot assume that authorities of other countries will take care of problems – entities that take risk must know what kind of risks they are taking. For example, in Brazil a foreign bank is investing; but by setting up a subsidiary that raises capital and rates the risks in Brazil – this is a possible model.

Raghuram Rajan, Professor, Graduate School of Business, University of Chicago

Critical issue in international institutions is not capital; it’s the DNA of the company – people, attitudes etc. So creating subsidiaries will have some of that DNA. But this doesn’t raise profound problems for the global system. Would central bank independence have helped? Hard for central banks to say aloof from domestic policies and pressures in society – answer is to fix the pressures in society, not make central banks more independent of them. Monitoring the supervisors is extremely important.

George Soros, Chairman, Soros Fund Management

No great mystery about what went wrong. Everybody was at fault – all acting on a false understanding of how markets function; that markets can correct their own excessives. Fact is that financial markets are inherently unstable. ‘Irrational exuberence’ – it was not irrational. If I see a bubble, I buy – it’s rational – and hope to sell before it collapses. THis means regulators have to accept responsibility for preventing asset bubbles from getting to big; they have refused to do so because they don’t think they have the instruments. Therefore need old instruments – we must control credit (monetarist idea that it’s about money supply is wrong) Market participants and regulators have to understand risks. Huge problem is that banking system has an implicit guarantee from authorities that they won’t be allowed to fail – therefore need to be controlled more so that they will not fail. Regulators have to learn about how markets function. Governments had to step in to replace collapsing credit – injected tremendous amounts of liquidity. This must now be shrunk as private credit revives. It’s too early at the moment. Biggest problem will be in the United States. US will be slow in recovery – 25 years of excesses to work off. Stimulus is working, but will require another dose. Europe has been less damaged – consumers less damaged, social safety net has paid off – slower growth in good years, but less damage in the time of collapse.

Raghuram Rajan, Professor, Graduate School of Business, University of Chicago

Moral hazard is the central problem coming out of the crisis. One solution suggested has been to break up the banks. Not convinced that the banks are too big – there are diversification benefits of large banks, but they are hard to manage. In Great Depression suggestion was that banks were too small. Need to restructure banks that behaved badly. Not convinced by creating different kinds of banks; bringing back Glass-Seagal. ANy unregulated part will create problems for the whole. Agree that they should have more capital – but need to focus on contingent capital – having capital at the right times. Need incentives to be less complicated. Separately incorporated subsidiaries makes sense – they can fail without the whole multinational failing.

Henrique Meirelles, Governor, Central Bank of Brazil

Credit bubbles and asset bubbles are very dangerous. Addressing this is not a question of monetary policy. A question of prudential regulation. Some countries are making improvements in assessing asset prices.

Lorenzo Bini Smaghi, Member of Executive Board, European Central Bank

Need to look better at what good supervisors did in some countries. Those countries where supervision was within the central bank did better than when it was outside. WHen central bankers start seeing fast growth of credit they should start questioning their models. Inflation targeting alone prevents this. Countries should detach themselves from the US – so they implement their own monetary policies and get rid of dollar pegs.