Leaders of the world's biggest developed and emerging nations put banks and investors on notice they will need to hold more capital and reveal more about their holdings, signaling the industry may emerge from the current crisis with less potential for profit.
President George W. Bush and his counterparts from the Group of 20 blamed a looming global recession on imprudent investors who “sought higher yields without an adequate appreciation of the risks.” Supervisors who failed to address the dangers building in markets were also at fault, the group said in its statement after meeting Nov. 15 in Washington.
The leaders are seeking to correct those failures with their new demands, particularly higher capital standards and stronger risk management at banks, hedge funds and credit-rating firms.
“What they're looking to do is to erect a new global financial architecture through improved regulation,” said Peter Hahn, a fellow at London's Cass Business School and a former managing director at Citigroup Inc. “Inevitably more regulation is going to make financial services less profitable and should rein in excessive risk.”
Writedowns and losses totaling $964.6 billion at financial institutions worldwide have triggered a surge in the cost of credit, cutting off access to capital for consumers and companies.
Chief among the changes sought by the G-20 are ways to increase international surveillance of the financial firms whose operations, and problems, cross national borders.
Hold More Funds
Banks that take on more risky structured credit, such as collateralized debt obligations, and securitize loans would need to increase their capital. That would likely limit the amount they can make selling such products.
“They want to enforce a smaller, more prudent banking system,” said Charles Goodhart, a former policy maker at the Bank of England. “If banks are required to hold more capital then clearly the rate of return on it will go down.”
While the leaders promised to “avoid over-regulation,” Mark Cliffe, chief economist with ING Groep NV in London, warns “efforts to make the system more robust may make recovery harder in the short term” if the prospect of tougher rules forces already skittish lenders to retrench even further.
The G-20 also indicated openness to so-called dynamic capital rules, which would oblige lenders to accumulate excess cash during periods of high profit as an added cushion for times when losses increase. Finance ministers were tasked with making recommendations for “mitigating against pro-cyclicality in regulatory policy.”
Capital Levels Dwindled
As banks and securities firms pioneered new products, including subprime mortgage loans and asset-backed securities, their capital levels dwindled compared with historical averages.
A report by the Bank of England last month showed capital ratios at U.S. commercial banks have plunged to less than 10 percent of assets from over half in the mid-19th century.
“There seems to be an inherent tendency for financial systems to cause periods of booms, by building up imbalances, and then to go through busts,” European Central Bank President Jean- Claude Trichet said Nov. 13. “We need to introduce a framework to dampen this phenomenon.”
The framework would include requirements for institutions and large investors, including hedge funds, to provide “complete and accurate disclosure” of their financial conditions, the leaders said, without specifying how that would be provided.
Hedge-fund managers appearing before the U.S. Congress last week largely supported the concept of more disclosure, while arguing against stricter regulation.
`Grave Mistake'
“It would be a grave mistake to add to the forced liquidation currently dislocating markets by ill-considered or punitive regulations,” George Soros, chairman of the $19 billion Soros Fund Management, said Nov credit score. 13.
Just a day after the G-20 authorities suggested they would consider limiting compensation that rewards excessive short-term returns or risk taking “through voluntary effort or regulatory action,” Goldman Sachs Group Inc. announced its seven top executives would forego bonuses this year. Goldman Chief Executive Lloyd Blankfein took home almost $70 million in salary and bonuses in 2007.
The G-20 also urged a “broader policy response” to slumping growth, citing the potential, if not a promise, for more interest-rate cuts and fiscal stimulus. They pledged not to erect protectionist barriers for 12 months and to devise by year-end a way to conclude the Doha round of trade talks.
Rather than take the same steps together, nations should act “as deemed appropriate to domestic conditions,” the leaders said in their statement.
Immediate Action
“There doesn't seem to be harmonization on immediate action to get us through the next quarter,” said Carl Weinberg, chief economist at High Frequency Economics Ltd. in Valhalla, New York. “And that's what matters for markets at the moment, not regulatory changes for the next decade.”
In another move to calm volatility, the G-20 endorsed central clearinghouses for financial derivatives to back trades and absorb losses in case of a dealer failure. That would likely slow the market's growth. Regulators in the U.S. agreed Nov. 14 on rules allowing the first clearinghouse for the $33 trillion credit-default swap market to open by year-end.
“There are certain initiatives on which they can move very quickly,” said John Taylor, a former U.S. Treasury undersecretary and now a professor at Stanford University. “A clearinghouse is something that could be up and running within a month.”
To further protect investors, swaps and other derivatives should be traded on exchanges or electronic-trading platforms, the leaders said, and more disclosure should be required for derivatives traded over the counter.
Unresolved Issues
Left unresolved after the summit is how much power the regulators will have. European leaders, including French President Nicolas Sarkozy and German Chancellor Angela Merkel, pressed for some form of state control over lending practices and investing across borders.
Bush, with only two months before he leaves office, opposed any movement toward a global authority over financial markets. The G-20 did agree that any new rules will be guided by free- market principles.
By pushing off consideration of their recommendations to April, European leaders may be hoping for a more favorable hearing from President-elect Barack Obama. Sung Won Sohn, a professor of economics and finance at California State University Channel Islands, said that may be a mistake.
“Obama may have some differences, but he is expected to subscribe to the basic principle” that there's danger in over- regulation, Sohn said.
The G-20 finance ministers were given until March 31 to come up with plans to implement the proposals. The leaders convene again in April, most likely in London.
G-20 members are Argentina, Australia, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, South Korea, Mexico, Russia, Saudi Arabia, South Africa, Turkey, the U.S., the U.K. and the European Union. The Netherlands and Spain were also represented.
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