Friday, January 8, 2010

>The new world regulation: between words and reality (CITICS SECURITIES)

OVERVIEW: The S&P 500 and Eurostoxx continued their rally toward the year end of 2009. Since they reached their trough at the end of February 2009, the two indices have rebounded by more than 60%. This dynamism results from a quicker than expected recovery of the US labor market, and from the resilience of households’ expenditure. Despite very high level of unemployment rates, industrialized economies seem to be on track to exit the recession and distance themselves from a deflationist scenario. Banks continue to repay the
financial help of governments. The Dollar is stabilizing. Finally, everything seems to indicate a reversal to the pre-crisis world, casting doubt on the utility of the promised new world regulation.

Focus: The new world regulation: between words and reality
The devastating effects of the crisis in terms of jobs and wealth destruction had prompted global leaders to coordinate their responses. This coordinated response emerged from a consensus on three necessities:

  • To quickly bail-out the banking system
  • To conduct expansionary monetary and fiscal policies to support the demand in the short term
  • To fundamentally reform the global financial system, in order to avoid repeating the mistakes of the past

The first two instruments of economic policy have produced good results as banks are not in danger any more and economies have generally come out of the recession in 3Q09. Nevertheless, the third lever of the post-crisis global policy, the reform of financial system at global level, takes a lot of time, and the incentives to reform will become weaker and weaker as time passes and economies stabilize. We illustrate this stalemate of the new world regulation in four points. First, we assess the progress made in relation to the G20 proposals for reforming the global financial system. The first observable results, notably in terms of prudential ratios, leverage and liquidity policy of banks could appear only from the end of 2012. The Financial Stability Board still considers that the risk management of banks leaders remains poor.

Second, we explain why the implementation of the equivalent of a Tobin tax seems to be impossible despite the support of several European countries. Then, we analyze the small success accomplished during the Copenhagen summit as another example of the difficulties of the new world regulation. In a post-crisis context, the lack of long-term vision of governments and national priorities limit initiatives on global redistributive policies. At last, we believe that the real issues at global level, i.e. excess liquidity, Dollar predominance, and public debt sustainability, are not covered by any initiative, which should in fact lie at the heart of the new world regulation.

The end of this year has seen UK’s and France’s decision to tax up to 50% of the highest bonuses of the banking industry. The Copenhagen summit was also at the center of the spotlight in December. These two events, which do not seem to be related to each other, may nevertheless precede what could emerge as a new world regulation in the years to come, i.e. more socially-oriented economies, more ecologically-responsible models of growth. The
impact of the last crisis and the strength with which governments intervened to stabilize their economies suggest that a new world regulation will emerge rapidly.

Nevertheless, the most optimist reformers have quickly come to recognize that profound changes of the financial system and curbs of carbon emissions will be difficult and will take a long time. The UK’s and France’s example has not been followed by other major countries. The Copenhagen summit has resulted in a minimal agreement only. The reality of economics has one more time eclipsed the importance of social and ecological agendas. The
urgency of the situation, in terms of growth, employment, and financial stability, has prompted governments to favor short-term issues to the detriment of forming a long-term vision. Moreover, the growing complexity of economic relations at the global level makes reform increasingly more difficult to coordinate. At last, the emergence of a bipolar
world where the US and China predominate, makes the harmonization of rules hazier than a recent past characterized by a uni-polar world.

We will see that the difficulties of reforming the financial system are paradoxically related to the growing strength and continuing weakness of the banking sectors. The most important actors have come to depend less on support from their governments, and have paradoxically more market power as a result of consolidation of the banking industry. It is therefore increasingly more difficult for governments to impose a new system of regulations and remuneration. At the same time, the difficulties of the smallest banks, namely the regional banks in Europe and in the US, make the highly capital-consuming new standards hard to implement. The growing competition between Asian and Western financial centers only heightens the difficulties of harmonizing rules.

The resurface of the Tobin tax debate from time to time casts doubt on the possibility to organize a more sustainable and egalitarian model of growth. Such a tax has been envisaged to solve the problem of financing climate change, for taking control of international capital flows, and for organizing an insurance system in case of shock on banking institutions. We will see in the second part that it will be difficult for these ideas to materialize.

The growing market share of Asian financial markets, existence of potential free riders like fiscal paradises, and growing needs of governments in terms of fiscal revenues for domestic purposes, make the coordination for such a global question quite impossible.

Mirroring the stalemate of new world regulation, Copenhagen has exhibited a typical dilemma, i.e. a universal recognition of the needs to curb global warming against national interests in the aftermath of the crisis. The decoupling of macroeconomic conditions, bipolarization of the world, lack of political vision, and fragility of governments, make the global environment less conducive to forging any kind of agreement. Moreover, the real issues of the world regulation, e.g. the path to be taken by the Dollar, control of excess liquidity, and reduction of public debts, have not yet received serious attention that they deserve.

Difficulties concerning the implementation of new financial regulation
The G20 summit of Pittsburgh in September 2009 has paved the way for an ambitious overhaul of world regulation. In the aftermath of the crisis, the ambitions of political leaders were clear: to give more weight to emerging countries in international negotiations, to strengthen the capital basis of banks globally, to initiate a better monitoring of complex financial activities (improvement in transparency), to implement reasonable compensation practices and better coordination of monetary and fiscal policies.

As of now, the only real decisions taken after the wave of recapitalizations in industrialized economies is in compensation practices. The British government has decided to tax 50% of discretionary bonuses above GBP 25K. The French government shortly followed the British example. Such decisions are indicative of sound progress in terms of risk control, as overly generous wage compensation policies can lead to excessively risk-taking behaviors. But we will identify several limitations of this approach.

First, even if other governments regard the British and French initiatives positively, as in case of Germany, chancellor Angela Merkel did not decide to take further action. In the US, Congress has already rejected the idea. Moreover, the decision to tax bonuses may not curtail overly high compensation. The UK and French banks may decide to absorb the tax hike and not pass the pain to their employees.

To read the full report: NEW WORLD REGULATION