30 October 2008

Thoughts on the reform of the International Financial System

Initially, it would be very useful to reach an agreement in principle on some of the more delicate questions, including the “representatively” of the negotiators or dealing with “responsibilities” and “sanctions”, so as not to get waylaid by formal and conceptual aspects to the detriment of substantive matters. Only then will it be possible to restore the confidence and create the necessary conditions for the market to fulfil correctly its intermediation function sustaining economic growth which is the foundation of social progress.

Initially, it would be very useful to reach an agreement in principle on some of the more delicate questions, including the “representatively” of the negotiators or dealing with “responsibilities” and “sanctions”, so as not to get waylaid by formal and conceptual aspects to the detriment of substantive matters. Only then will it be possible to restore the confidence and create the necessary conditions for the market to fulfil correctly its intermediation function sustaining economic growth which is the foundation of social progress.

 

There are three fundamental aspects which, though distinct, are nevertheless deeply interdependent: the legislative framework, the regulatory environment and the private sector sphere. Obvious weaknesses have emerged in all three areas which have contributed to the current financial crisis.

 

On the legislative front, the corpus of laws, in particular those having a repressive character are totally outdated.  One attempts, often in vain, to deal with transgressions, mainly in the area of “responsibility” within the scope of general legal concepts that were neither designed for - nor adapted to - the complexities of financial markets. This situation leads to a dilution of responsibility – often hiding a glaring level of incompetence –as well as a feeling of impunity, both of which have been powerful factors in the misuse of structures, techniques,  financial vehicles and products which were, otherwise, often ingenious and legitimate. 

 

It is therefore imperative to review in depth the legislative framework of financial markets and to define precisely the responsibilities of the various actors.

 

For example, it is necessary to strengthen considerably the powers of regulators and shareholders to undertake legal action for failures or incompetence of managements and/or Boards of Directors to discharge properly their mandates. The framework should apply at a minimum to all listed companies. In cases where companies exercise activities that include aspects involving “public good” services, such as the gathering of deposits, stock exchanges, investment advisory or discretionary mandates, the corresponding standards should be strengthened.

 

Reprehensible conduct should be effectively restrained through specific legal/regulatory measures: for instance, the adoption of the following three rules would carry a strong emblematic message.

 

a)    Forbid reciprocal appointments of Directors in listed companies. Such a rule would avoid the temptation of an implied understanding of mutual “non interference”. This attitude often leads to Directors foregoing their statutory obligations towards shareholders.

b)     Deprive any person found guilty of a transgression linked to a mandate of Director or employment contract the right to exercise a mandate of “Director” for a period of 5 years (as is the case for politicians). The effectiveness of this measure is that the sanction cannot be covered – as are purely financial penalties – by insurance policies and therefore reaches out to the “ego” of those concerned as well as to their wallet.

c)    A resumption of control over Exchanges by a supranational authority in order to ensure coherence of basic principles as well as, through a decentralised supervisory system, allow for regional or national specificities. This measure is suggested in recognition of the “public service” aspect of the functions carried out by exchanges: most of these have demonstrated in the current turmoil their ability to act to provide a “counterparty of last resort” at a time when many other markets were seriously impaired. This function is too central to the health of the economy in general to be entrusted, as is the case today, to a governance model which is largely accountable only to the private sector.

 

Other penal aspects to be considered within the framework of legislative reform derive from the global character of financial markets: particular attention will have to be devoted to the questions of jurisdictional competence, international judicial cooperation, application of sentences etc.

 

Let us now turn our attention to the regulatory context. A first similarity to the legislative aspects results from the fact that, in most instances, the legislation that institutes the regulatory framework of the financial market has not followed its developments rendering the performance of surveillance mandates particularly complex and inefficient. The conglomeration of financial sectors that has accelerated considerably over the last twenty years has subjected operators to an ever growing number of independent Regulators whose respective mandates varied from one country to another.

 

This proliferation of Regulators occurred on two levels: first at national level were different sectors – commercial banking, investment banking, brokerage, or insurance – were the responsibility of different Regulators and, secondly at international level where a single institution was subject to multiple reporting requirements in each country where it operated. Up until very recently, Governments (particularly within the EU) were satisfied with fostering “reinforced cooperation” between existing Regulators. It has become patently evident that such an approach is inadequate and handicaps both Regulators in the performance of their duties as well as dilutes responsibility to the point where it becomes meaningless.

 

It is therefore necessary to reinvent, from its foundations, the architecture of the regulatory framework of financial markets. I have already had the opportunity of suggesting a three tiered pyramidal structure involving a global, a regional and a national level in which supervision would be exercised at the level where an institution is licensed to operate. From the point of view of activities, one will have to address the question whether the conglomeration of various financial sectors is advisable or whether it is necessary to reinstate a measure of legal separation between some of the financial services. To the extent that a measure of separation is adopted, an equivalent division of supervisory segregation would be called for.

 

In addition to the question of the architecture, one must also address the question of resources without any preconceived ideas. One of the reasons that have impaired Regulators in discharging their mandates effectively is an obvious lack of resources. The growing disparity between the remuneration of private sector agents in the financial sector and that of public servants has created a deep chiasm limiting the ability of Regulators to attract competent staff, capable of understanding the implications of innovative financial products of growing complexity. Correcting this situation would only require a small fraction of the resources that Governments have recently allocated to the rescue of the financial system and should constitute one of the first priorities of the reform.

 

At the end of the process, it will be necessary to design an adequate framework defining the responsibilities of Regulators. It could be inspired by the rules that are being considered for the regulation of Rating Agencies. Indeed, by using similar standards for these two very different activities, one will avoid the temptation to legislate - in both cases - in a fashion that would limit the effectiveness of the services that they are expected to deliver.

 

As for the detailed content of the regulations, adequate time is required: any undue haste provides for bad rules. The regulatory framework should aim at creating a robust market surveillance system that is capable, in normal circumstances, to anticipate correctly the warning signs of any significant deterioration. Detailed drafting should be seconded to expert groups, whose objectives should be properly defined.

 

It is in this area that the political dimension of the negotiations will appear with all of its significance: indeed, in defining the objectives, one will have to take fully into account the legitimate wishes of emerging countries as well as those still in a state of chronic under-development and who find themselves, for the first time, fully associated in the reform process. This implies a fundamental change in the attitude of developed nations; it behoves them to show the political courage to convince their respective national opinions that it is in their own best interest to give full support to a comprehensive reform process.

 

Efforts will be required by all participants, as it is essential to provide effective means to fight corruption, to implement a system that eliminates “tax havens” and other blatant injustices that have wormed their way deeply into the fabric of our societies. This fight could be particularly productive if it took into account one of the most important risks exposed in the current crisis: the management of “counterparty risk”. One should consider a global “licensing” system that would confer the status of “authorised financial intermediary” and which would ensure the transparency of financial circuits thereby becoming an effective tool in the fight against fraud in all its guises as well as against other scourges such as international terrorism.

 

As for the role of the private sector, one can not use the reinforcement of the legislative and regulatory framework as an alibi for minimising efforts in governance and self discipline. Until proven otherwise, the market economy system remains the most productive invented by “homo economicus”. The errings that it engendered are largely the result of human urges of power and cupidity which, if not properly controlled, lead unavoidably to the excess we are witnessing.

 

This leads to the question of individual responsibility and sanctions. There can be little doubt that there is a large part of collective responsibility in the current situation at all levels: of public authorities (executive, legislative and judiciary) of economic actors both public (Regulators and Central Banks) and private (bankers, directors, investment managers, investors, consumers etc.). This is why the need for reform is accepted universally. 

 

This does not mean that specific sanctions should not be sought or applied, each time that proof of transgression can be established. It calls for a strict enforcement of existing laws (without retroactivity). Where a guilty verdict cannot be obtained, appropriate changes in laws and regulations to correct loopholes and avoid their continuation should be considered. Such legal actions should be undertaken vigorously – as exemplified by legal actions in the French Savings Bank or Fortis cases -  by the appropriate public bodies as well individuals or private organisations that consider that they have been wronged by the irresponsible behaviour of duly appointed agents (Directors and/or employees).

                  

The challenges to overcome indicate that efforts should be centred on the establishment of a more just financial system in which transparency and responsibility are the main pillars. One must hope that the leaders will not allow themselves to be guided by narrow political interests and will discharge with the necessary courage their difficult task: to carry out an in depth transformation of the financial system that the world both needs and deserves.

 

© Paul Goldschmidt