First draft: January 31, 2000
Reconciling Global Financial Markets and National Regulation: The Role of the Bank for International Settlements
by
Michele Fratianni* and John Pattison**
*W. George Pinnell Professor of Business Economics and Public Policy, Indiana University, Kelley School of Business, Bloomington, Indiana 47405 (USA). Tel 812-8559219, Fax 812-855-3354, Email
[email protected]. **Senior Vice-President, Canadian Imperial Bank of Commerce, Commerce Court West, 199 Bay St., Toronto, Ontario, M5L 1A2 (Canada). Tel 416-980-5306, Fax 416-3689826, Email
[email protected]. The views expressed in this paper are those of the authors and not those of their respective organizations. We thank for comments and suggestions, without implicating them for errors of commission and omission, Andrew Crockett, Allan Meltzer, Charles Calomiris, Lee Hoskins, Jeffrey Sachs, and George von Furstenberg for comments on an earlier version of the paper. This paper was funded by and prepared for the Political Economy of International Monetary and Financial Institutions, Center for German and European Studies, UC Berkeley, Berkeley, CA 94720-2316.
Abstract
The international financial architecture (IFA) literature, in contrast to the literature on the international monetary system, is concerned with micro and institutional questions. These days, it is searching for a set of best principles and practices that may lower the risk of financial crises and spillover effects. Our paper considers what role the Bank for International Settlements (BIS) may play in the new IFA. The BIS is an old, yet relatively unknown, international organization. Originally created to provide a definitive framework for German war reparations, it quickly became a central banks’ club. With the end of the Bretton Woods system, the BIS lost many of its roles. But the Bank moved quickly into the field of international financial regulation and financial standards after the failure of Bankhaus Herstatt in 1974. Today the BIS, in contrast to the IMF, is an ascending institution because of its role in promulgating financial standards. We argue that a coordinated strategy to international regulation is superior to either national regulation or to an all-powerful World Financial Authority. A coordinated strategy involves setting minimum standards, through the auspices of the BIS Group. These standards will have to be adopted voluntarily by countries and will have to be enforced locally. Given the strong asymmetry of information in banking, the critical challenge of setting financial standards is in the implementation. Our implementation scheme relies on a combination of competition and dominant country position. A small group of countries has a disproportionate share of the international banking market and can exert strong leverage in inducing other countries to adopt minimum standards. There is also the need for an international organization to be a lender of last resort to those countries that, having adhered to the standards and having good fundamentals, are caught in financial turmoil through no fault of their own.
Key words: international monetary system, international financial architecture, interdependence, contagion, regulation, and standards. JEL Classification: F33, F34, G18.
I. DEFINING THE ISSUES In the wake of the Asian currency crisis of 1997 there has been a flurry of proposals to reform the international monetary system.1 Many of these proposals have had international financial architecture (IFA) in their title to suggest a rebuilding of institutions that would shore up or fortify the current international monetary system. The IFA literature, in contrast to the literature on the international monetary system, is primarily concerned with micro and institutional questions; in particular, it is searching for a set of best principles and practices that may influence the behavior of both private and official agents operating in the international financial community (Saccomanni, 2000). The Report “Strengthening the International Financial Architecture” (G-7 Finance Ministers, 1999), written by the G-7 Finance Ministers for the Cologne Economic Summit and approved by their leaders, is the most recent and authoritative example of this approach. In this document, the heads of state of the most industrialized countries are both cautious, in the sense that they desire to retain the bulk of the old architecture, and eclectic in the few modifications they propose. They are conservative by refusing to endorse any new international organization and by placing the International Monetary Fund (IMF) and the World Bank at center stage of the new IFA. They are eclectic in elevating the Bank for International Settlements, its sister institutions, and the OECD to the role of codifying best practices in banking, financial markets, and corporate life.2 They innovate by endorsing the new Financial Stability Forum and its objective of enhancing “international cooperation and coordination in the area of financial market supervision and surveillance.” (G-7 Finance Ministers, 1999, p. 3). Today’s IFA is a web of institutions with overlapping jurisdictions. Table 1 gives a road map of those international organizations and clubs that are involved in the world of international money and finance. Much as we have tried to simplify the table, the overall view remains one of complexity, the result of historical experiences and ad-hoc institutional building. The topography of the current IFA is reminiscent of the topography 1
Eichengreen (1999b, Appendix A) lists a series of reform proposals, to which one must add that by the Council on Foreign Relation (1999). 2 We consider IOSCO and IAIS as sister institutions of the BIS Group (see Table 1).
of a city, where different architectural styles coexist. The approach of caution and eclecticism of the G-7 Report is rooted in the uncertainty on the causes and international propagation of financial crises. Caution is also dictated by the political reality of financial regulation and supervision. The well-delineated architectural structure of a supranational global financial regulator, global bankruptcy court and global central bank are undesirable and unachievable to most governments.3 These governments are not about to delegate responsibilities of financial regulation to a potentially non-accountable and unresponsive supranational entity (Eichengreen, 1999a, 1999b). Likewise, the sharp architectural structure of atomistic national regulation, unlinked by commonly agreed codes of good conduct, was unpalatable because of the domino effect risk. There is a widespread belief that the risk of contagion rises in an environment of liberalized and integrated national markets. This contagion is feared by the policymaker and the public at large, and may be responsible for the rising resistance by influential sections of the population to further attempts to integrate the national economies. [Insert Table 1 here] The architects of the IFA are aware that they cannot build crisis-proof structures without at the same time destroying the benefits of financial integration. There seems to be no desire to create impregnable fortresses, as they existed in the Soviet Union or in today’s North Korea, or for that matter in Italy of the Seventies. The challenge is to minimize the frequency and size of financial crises and to bring those crises that emerge to conclusion, without instigating moral hazard behavior and while preserving financial integration. Without mentioning explicitly moral hazard, the G-7 Report acknowledges that the current environment is too risky and recommends that policies be designed to lessen these risks (p.6):
The past two years have reminded us that investors and creditors often tend to underestimate risks as they reach for higher yields. In periods of market euphoria, market participants can make credit and investment decisions that might not otherwise have been made. In hindsight, the failures on the part of lenders and supervisors in the major countries include poor risk management practices,
Again continuing with the city similitude, it takes a tyrant like Nero to burn a city to re-build it more beautiful.
inadequate information as well as inadequate attention to available information, and capital standards that provide unintended incentives to lend to risky borrowers. Such excessive risk taking, combined with high degrees of leverage, can magnify the negative effects of any event or series of events. The G-7 formula is broad and includes, in addition to strengthening and reforming international financial institutions and arrangements, the promulgation and implementation of best practices, stronger financial regulation, sound macroeconomic policies and financial systems in emerging markets, more transparency, and social policies to protect the poor (p. 2). Our paper deals with one particular aspect of the recommended IFA, namely the role of the BIS and its sister institutions –refer to Table 1 for a definition of the BIS Group-- in promulgating codes of best practices and as a possible provider of international lender of last resort facilities. We have chosen the BIS for several reasons. First, the enigmatic BIS is an increasingly important institution in the new IFA. The rise of the BIS precedes the recent difficulties of the IMF: it is grounded in the comparative advantage that the Bank has created for itself in the area of final regulation and supervision. The relative obscurity and exclusivity of the club has permitted the BIS to refocus its mission from central bank cooperation to being a catalyst for the promulgation of regulatory standards and best financial practices. The success of this institution to keep its membership small and homogeneous and to narrow down its institutional mandate stands in sharp contrast to the increasingly broad agenda of the IMF. The IMF has a universal and heterogeneous membership and has expanded its objectives to the point that its effectiveness has diminished and its competence is in question. The critics of the institution are numerous. A representative sample includes Feldstein (1998) who finds that the IMF inappropriately intrudes into areas that are the traditional domain of the country’s domestic economic policy; Meltzer (1998) and Calomiris (1998) who blame the IMF for too much lending, soft conditions, and encouraging moral-hazard behavior; Sachs (1999) who believes that the institution has failed to be a true lender of last resort; and Willett (1999), a sympathizer of the IMF, who recognizes that the seal of approval of the institution has been tarnished by mission creep. The relative decline of the IMF has moved from the pages of academic journals to the agenda of policy makers. The U.S. Treasury
has signaled its desire to refocus the IMF more narrowly, away from long-term financing and towards short-term financing to countries in crisis (see, for example, Financial Times, 2000). In sum, the implicit mandate of the G-7 Report and the relative decline of the IMF augur well for the future of the BIS Group –the BIS itself and its sister institutions—to play a critical role in financial regulatory matters. It is this role that we intend to explore in this paper. In the remainder of the paper we proceed as follows. We start with a brief reminder for having financial regulation (Section II), before providing a framework for international regulatory cooperation and standard setting (Section III). The discussion of the BIS spans over the next three sections: Section IV looks at the historical evolution; Section V focuses on the shift from policy coordination to standard setting in the wake of the demise of Bretton Woods; and Section VI gives an over-all evaluation. The implementation of the standards is dealt in Section VII and the international lender-of-last resort facility in Section VIII. Conclusions are presented in Section IX.
II. WHY REGULATION AND SUPERVISION There are three basic reasons for regulating banks. The first is to prevent the failure of a bank spreading to healthy institutions. Bank depositors tend to panic because they have incomplete information on the quality of a bank’s assets when faced with systemic risks; prudential rules are designed to constrain the risk exposure of banks and, consequently, to reassure depositors that the system is sound. The second is to protect small savers who have relatively small information endowments, low incentives to acquire new information, and a strong preference for holding liabilities of financial institutions that carry no default and interest-rate risk. The safety of bank deposits is guaranteed either by deposit insurance schemes or by central banks extending the protection of the lender-of-last resort function. The final reason is to protect producers from the effects of competition. Typically, governments provide the regulatory structure and the safety net to financial institutions. These two aspects are intertwined. Since taxpayers bear the cost of financial crises, governments, acting on behalf of taxpayers, limit and constrain the risk that financial intermediaries can take to minimize the burden on taxpayers.
Before the Great Depression of the Thirties, the burden of financial crises fell directly on the affected parties; the taxpayer’s deep pockets were seldom called upon. The experience of the Great Depression altered fundamentally the rules of the game. To avoid the large consequences on output and unemployment from financial crises governments erected safety nets. But those nets altered the propensity of financial institutions to take risk with the expectations that eventual losses would be collectivized. Safety net and moral hazard are the horns of the dilemma for public policy (IMF, 1999, p. 74). One cannot exist without the other. There is a general consensus today that risk taking has increased (IMF October 1998, p. 95, p. 96, and p. 103). For some authors this higher risk is largely attributable to moral hazard behavior (Calomiris, 1998; Meltzer, 1999; Calomiris and Meltzer, 1999). Deregulation and liberalization have contributed to a riskier environment. There is some evidence that countries that experienced a financial crisis had previously deregulated their financial system (Williamson and Mahar, 1998; Kaminsky and Reinhart, 1999; Goldstein and Folkerts-Landau, 1993). These findings can be explained by institutions seeking more profit opportunities as economic rents are being eroded by the liberalization program. Unfamiliar with the unregulated environment, banks take excessive risk before finally learning the new risk management techniques and settling into a new steady-state equilibrium (Llewellyn, 2000). In sum, the case for regulation and supervision stems from the safety net governments provide to the financial system. Governments can react to increased risk taking by either making the safety net less predictable with the intent of lessening moralhazard behavior or by tightening the regulatory regime or by a combination of both.
III. REGULATION AND SUPERVISION IN AN INTERNATIONAL CONTEXT
There are three possible approaches to financial regulation and supervision in a world of integrated financial markets: national regulatory competition, one world financial authority, and a coordinated approach with national enforcement.
National regulatory competition National regulatory competition is the principle adopted by the EU in the specific sense that the authorities of the home country have the right and obligations of regulating banks they have licensed regardless of where they operate in the defined area of integration. Since each member state accepts this principle, national regulatory standards are mutually recognized. The advantage of this principle is two-fold. First, “excessive” or “lax” regulation faces competition. Regulated firms can engage in regulatory arbitrage by changing location and regulator. This arbitrage, however, is subject to the policing of the market. Risk-averse depositors will prefer a highly regulated environment to a lesserregulated environment. The second advantage is that regulatory competition is an efficient institution to achieve convergence of regulatory standards. The disadvantage of regulatory competition is that the equilibrium solution may entail chasing the lowest common denominator, that is a standard so low to make the financial system excessively prone to crises and to taxpayers’ bailouts. To avoid the chase to the lowest common denominator, the EU has set a minimum floor through a spate of Directives (Fratianni, 1995, p. 162). But the larger the number of countries involved --and hence the more heterogeneous—the more difficult it is for member countries to accept the principle of mutual recognition. This is quite natural because mutual recognition is based on trust: members have a similar approach to risk and regulation.
A World Financial Authority The polar case of national regulatory competition is a World Financial Authority, as Eatwell and Taylor (2000) call it. The argument for creating a single world regulatory authority is that it would eliminate the wasteful activity connected with regulatory arbitrage and would achieve the efficiency and the externalities of a regulator whose reach coincides with the market reach of internationally active banks. How can regulation remain national if markets are internationally integrated? A single world regulator would not suffer from the inconsistencies of numerous national regulators. A world regulator would not face the coordination costs of getting national regulators to agree on a standard. A
world regulator would not have the incentive to deviate from the coordination strategy, as is likely in a regulatory cartel. Eatwell and Taylor seem to have no doubts that a World Financial Authority is the only sensible solution to the new global environment (pp. 26-27): “…the recent crisis in Asia and its contagious spread to Russia, South Africa, and Latin America has demonstrated beyond all reasonable doubt that information and coordination are not enough. It doesn’t matter how many numbers are available or how transparent financial institutions might be, the market still underprices risk and is still systematically inefficient. It doesn’t matter how many national regulators sign up to common standards if there is no enforcement procedure to ensure that those standards are met. And it doesn’t matter how effective national financial authorities might be, if, when global financial crises demand concerted action, they cannot provide a swift, unified response. The affection for a world financial authority is reminiscent of the utopian solution of a world government to solve violent conflict among nation states. A single, benevolent supra-national regulator –one would argue-- would not deviate from the “best” solution, whereas a national regulator in a regulatory cartel would be tempted to “cheat” or deviate from the cooperative equilibrium. But is it not far fetched to think that an all-powerful world regulator would be benevolent? Without accountability, there is the danger that a single authority would be so singly focused to prevent a financial crisis that it would set an excessive regulatory burden, with the consequence that the world community would pay the cost of stymied competition, innovation, and product differentiation. Competition is just as much of an engine of discovery in regulation as it is markets. How could one stop a single authority from becoming bureaucratic, narrow, and inflexible? As the power of the single authority rises, so would the rewards for pursuing a strictly regulatory approach over the alternative of market friendly regulation. In the absence of competition, the only route for forcing change would be to amend the international agreement that created the single authority. The exit cost to a single country would be very large, excessively large. The high secession cost would keep the system stable and encourage the single authority to be unresponsive to the wishes of the constituencies. Furthermore, would a single authority be able to assess risk in every corner of the world better than the local regulatory authority?
What would be the legitimacy of such an institution relative to national regulatory bodies that ultimately respond to voters? Would it not be unmanageable to administer regulation and supervision to the global financial system? Finally, a world financial authority would not be politically acceptable. Even within the confines of a homogeneous group like the EU, financial regulation and supervision remain at the national level. As William White (1999, p. 13) puts it: “oversight and supervision must be a very hands-on affair. This was one of the arguments used in Europe when it was decided that banking supervision would stay at the national level rather than migrating to the European Central Bank.”
International standards and the coordinated strategy The third and most promising approach to international regulation and supervision is to set international standards and let national bodies implement regulation and supervision. Goldstein (1997) has forcefully argued the case for standards of best practices --or what he calls an international banking standard--, not imposed from above but accepted voluntarily by countries with the stated purpose of increasing “the scope and pace of banking reform in both developing and industrial countries” (p. 61). Eichengreen (1999b) adopts Goldstein’s principle of an international banking standard for his proposal to redraw the IFA. The establishment of international standards is an exercise in coordination, necessitated by the erosion of national borders in matters of banking and finance. This erosion, in turn, reduces the power of regulators to contain systemic risks and to protect consumers within their jurisdictions. The 1997 currency turmoil in East Asia has heightened the sense of urgency in reducing systemic risk. For our purposes, it is useful to distinguish between “normal” or fundamentals-driven interdependence and exceptional, but temporary, interdependence caused by a shock to an individual country or set of countries.4 “Normal” interdependence has been rising since capital liberalization of the Eighties and the Nineties. Controls on capital movements and foreign exchange markets were responsible for large deviations from covered interest rate parity and for large differences between offshore and onshore
4
On this distinction and the relevant literature see Dornbusch et al. (2000)
interest rates.5 After France and Italy eliminated those controls in the late Eighties, onshore interest rates quickly converged to the level of their offshore counterparts (Obstfeld, 1995, pp. 209-10). In his study on financial integration for the G-5 countries, Marston (1995, p. 69) points that “…by the early 1990s, …the distinction between national and international money markets, at least at the wholesale level end, ceased to be important.” The extent of financial integration can also be gleaned from the size of private capital flows. At the end of the Eighties capital flows to the developing countries surged.6 The trend continued through the Nineties, with the exception of bank loans. Emerging market economies were steady recipients of foreign direct investment and portfolio investment in the period 1990-1998 (IMF, 1999, p. 53). Bank loans, instead, fluctuated. Large reversals of bank loans took place in 1995 (following the Mexican currency crisis) and in 1997-98 (following the East Asian and Russian crises). Even more impressive is the extent of cross-border transactions in bonds and equities for the industrialized world. Table 2 reports cross-border flows as a percentage of GDP for six countries. All of these countries have experienced dramatic increases. As an example, cross-border transactions for Italy literally took off at the end of the Eighties, when controls on capital flows and foreign exchange transactions were abolished. [Insert Table 2 here] The steep rise in international financial integration of the last decade is not a unique historical phenomenon. It brings us back to the environment that prevailed at the end of the 19th century (Obstfeld and Taylor, 1998). More than a hundred years of history of financial integration can be approximately described by a U: integration was high at the end of the 19th and 20th century, very low in the Great Depression and in the Bretton Woods system. John Maynard Keynes and Harry Dexter White, the founding fathers of this system had an antipathy for finance capital, which found its way into the Articles of 5
For example, Frankel and MacArthur (1988, Table 3) find that the average deviation from covered interest rate parity for the period September, 1982 to March, 1987 was –3.24 for 10 countries with capital controls and –0.66 for 13 countries without capital controls. 6 The capital surge was led by foreign direct investment. To a large extent, foreign direct investment flows were redirected from the industrial world to the developing world (Von Furstenberg and Fratianni, 1995, p. 21).
Agreement of the IMF. In sum, “normal” interdependence today is high but not unique in historical terms. What makes this period unique is that, unlike the governments of the gold standard, governments today are not willing to subjugate employment and growth objectives to the goal of exchange rate stability (Eichengreen, 1992; Obstfeld and Taylor, p. 397). This poses one more constraint on the system, which justifies the importance of an international set of regulations and standards. Financial contagion refers to an exceptional degree of interdependence that cannot be explained by fundamentals. Financial contagion puts at risk countries with good fundamentals and raises the question of what type of assistance the international community needs to provide to those countries that find themselves in financial turmoil through no fault of their own. In our plan, the existence of a significant degree of “normal” interdependence justifies the establishment of minimal levels of international regulation and international standards; the existence of contagion, instead, justifies the intervention of an international agency acting as an international lender of last resort (ILOL). “Normal” interdependence means that what happens to one country spills over to other countries through trade and capital account linkages. Markets are integrated and the geographical scope of regulation and standards must expand beyond the national boundaries. If the scope of regulation were to remain national, financial institutions would spend valuable resources in arbitraging regulatory differences and externalities would go unexploited. Contagion places at risk well-behaving countries, that is countries that adhere to good macroeconomic policies and financial standards. These countries deserve access to liquidity, if required, from an international organization to deflect the consequences of contagion. Countries cannot qualify for ILOL if they do not adhere to international standards. The implementation of the standards must be observed by the ILOL granting agency. One may argue that the important distinction between fundamentals-driven interdependence and exceptional interdependence is not yet fully operational as a practical guide to policy. In fact, the literature has had some difficulty in differentiating, theoretically and empirically, “normal” interdependence from contagion. Consider the
basic testable equation that the return on a country’s asset depends on a vector of fundamentals and on an idiosyncratic residual term. Presence of contagion can be inferred from the residual being correlated across countries. But, as Pritsker (2000) explains, there are two types of objections to this methodology. First, disputes are bound to arise as to whether the researcher has accounted for all relevant fundamentals. To give a flair of the literature, consider a few representative studies. On the one hand, Schwartz (1998) speaks of the myth of contagion; and Bordo (1999, p. 372) states unequivocally that: I know of no evidence of pure contagion. Transmission is another. Shocks to one country will spill over to other countries through trade and the capital accounts. On the other hand, Calvo and Reinhart (1996) present evidence that more than fundamentals were involved in the spillovers following the Mexican crisis; the same qualitative conclusion is reached by Baig and Golfajin (1998) for the 1997 East Asian currency crisis. The second problem with the distinction is due to the portfolio re-balancing effect. A currency crisis will instigate investors to sell assets that are highly covariant with the assets denominated in the currency of the crisis country. This action, in itself, creates the exceptional cross-country interdependence defined as contagion. But portfolio rebalancing is motivated by investors reacting to the fundamentals in the crisis country and thus cannot be taken as occurring independently of the fundamentals.7 The balance of the evidence to date is that contagion is difficult to measure separately from fundamentals-driven spillovers (Dornbusch et al. 2000, p. 15). Yet, the inability to distinguish between the two is not a justification for inaction. The implementation of international norms for regulation, including rules for competition, and best financial practices can reduce the risk of financial contagion by inducing countries to adopt better fundamentals. By improvement one’s fundamentals a country has a big chance of reducing contagion. The distinction between fundamentals-driven interdependence and pure contagion is critical, instead, for the administration of ILOL. But that distinction is no more difficult to sort out than the Bagehotian distinction between
7
On this point, see Pritsker (2000, p.2)
illiquidity and insolvency that national central banks must resolve for the administration of the lender-of-last-resort function at home. In sum, international coordination of minimum or floor national regulation and financial standards promises to yield better results than either national regulatory competition or a single supra-national regulatory agency. Also, this solution is consistent with the political realities that would make it impossible to delegate regulation to a nonaccountable and unresponsive World Financial Authority. The international coordination approach is neither easy nor fast. By the sheer size of the players involved, progress will not be linear: crises will accelerate coordination and financial calms will slow it down. In what follows, we will discuss the role of the BIS and its sister institutions may have in the creation of an international regulatory structure.
IV. FULFILLING THE NEED: THE ROLE OF THE BIS
In this and the following section we provide a rather detailed account of the BIS and its evolution over time. This lengthy treatment is justified by the fact that the mandate and operations of the BIS, unlike those of the IMF and the World Bank, are relatively unknown and shrouded in a mystique of central bankers’ club.
From War Reparations to the End of Bretton Woods The seeds of the BIS were sown in Paris in 1929 when representatives of the war reparations conference --Belgium, France, Germany, Great Britain, Italy, Japan, and the United States-- set up a Committee of Experts to provide a definitive framework of German war reparations (Dulles 1932, p. 4). The work of this Committee led eventually to the creation of the BIS in 1930 under Swiss charter. But war reparations were not the exclusive reason for creating the BIS. In fact, the heart and soul of the institution was, from the very beginning, central bank cooperation, which is enshrined in Article 3 of the Statutes. The bank was born as a central banks club (Dulles, p. 3). The ‘club’ was soon to be tested, in 1931, after Germany declared a bank holiday and went off the gold standard. Financial spillovers spread to London, which lost a
significant amount of gold in the process. The Bank of England raised the discount rate but gold flows did not stop. The Federal Reserve and the Banque de France came to a rescue with a loan of $125 million each (Dulles 1932, pp. 396-97). The countries tied to the gold standard were rocked by financial turmoil. The BIS tried to help but did not have sufficient resources to do it. The financial limits of the BIS were imposed by the signatories of the Statutes to make sure that the Bank would not trample over national monetary sovereignty. Article 25 of the Statutes, in fact, prohibits the Bank from acting like a central bank: it cannot issue “notes payable at sight to bearer.” Yet, the signatories made sure that the Bank would be independent of governments. The reason for independence was well expressed by Lord Montagu Norman, Governor of the Bank of England:
Whereas you (the Foreign Office) may be said to follow the policy of the League we, since its establishment, give the first place to the BIS, and therein lies an additional reason for us to encourage Central Banking and to avoid diplomatic contacts” (Clay 1957, p. 289). Given these precedents, it would have been almost inevitable for the Bank to emphasize central bank cooperation. And this it did. An early objective of cooperation was the restoration of the gold standard. Later, the bulk of the benefits of central bank cooperation came from the monthly meetings in Basel. For Norman Crump of the Bank of England the “…BIS function as a ‘club’ of central bankers is extremely important…[In its monthly meetings] there is no undesirable publicity and no rumors” (Financial Times, February 2, 1939 reported by Schloss, p. 91). The BIS was essentially a European organization because of its role in both central bank collaboration and the management of German reparations. The Bank did not play a critical role in the post-World War II economic institutional structure. As a matter of fact, the prevailing mood at Bretton Woods was to liquidate the BIS. One reason was a presumption that the institution had been too much under German influence before and after the war. The more important reason, however, was a feeling of antipathy for international finance (see Section III above). The mood of the times was captured by Henry Morgenthau who
… proudly declared at Bretton Woods that the Fund and Bank would ‘drive the usurious money lenders from the temple of international finance’. (Acheson et. al. 1972, p. 23)
Another concern about the BIS was its membership. The criticism was that it had to be universal and multilateral, rather than regional or limited to a small number of members. The BIS, because of its essentially European roots, was not seen as a good model. Bretton Woods –it should be remembered-- was planned while the European nations were still at war, and a number of them were enemies or under enemy control. As a result, the United States and the United Kingdom did much of the thinking about Bretton Woods with support from Canada. Harry White was bitterly opposed to the BIS. Keynes echoed White. In a letter to The Nation in 1929, Keynes ruled out that the BIS might form the “nucleus for the Super-National Currency Authority which will be necessary if the world is ever to enjoy a rational monetary system” (Bakker 1996, p. 89). According to Gardner (1972, p. 31), the greater design of Bretton Woods was that a new organization, the IMF, would occupy the central place in postwar monetary decisions: It was envisaged at Bretton Woods by both the US and Britain as well as everybody else that the International Monetary Fund would be the central place for taking decisions on the liquidity and adjustment problems. The BIS was seen primarily as a financial institution; and not only did it have a narrower scope than other international organizations, but was the target of the strong antipathy against central bankers that prevailed in the United States at the time. At the end, the BIS survived because the Europeans felt otherwise about central banks; and the Bank had been essentially a European institution. History seemed to have vindicated the European viewpoint. While not central in the design of the Bretton Woods institutions, the BIS played a useful role immediately after World War II. In the 1950s, the Bank was the agent of the European Payments Union (see Fratianni and Pattison (1999) for more details). In the Sixties, the Bretton Woods exchange rate parities started to come under significant strain. The BIS became a central point for the discussion of the management of these tensions. It played an important, yet informal, role. Arrangements
were made by central banks and among central banks. Given the small degree of capital mobility, monetary authorities were able to exercise considerable influence over exchange rates. The defense arsenal included mutual guarantees all the way to the prohibition of converting funds placed by foreign speculators. Guarantees were implemented by swap agreements among central banks. The Federal Reserve agreed to exchange currencies with other central banks for fixed periods of time, with the result that both parties would appear to have increased their foreign reserves. The BIS was a participant in these swap lines and played a central role since it could engage in more complex transactions among a group of countries.8 In effect, a group of central banks was managing the fixed exchange rate system in ways that their own governments could not. In the middle of the Sixties, the BIS began to analyze international financial markets and to provide regular reviews and analysis of the Eurodollar and Eurocurrencies markets, as well as quarterly statistics on the lending of banks in the G-10 and Switzerland to approximately 100 individual countries. In the Seventies, it began to worry about country risk and, against the skepticism of some observers, drew attention to the indebtedness of some Latin American countries and some Eastern European countries, well in advance of the debt problems of the early eighties. New institutional alternatives –alternatives to the traditional forum function of the BIS-- were created before the collapse of Bretton Woods. The G-10 started in 1963, emerging from previous consultations under the “General Arrangements to Borrow” to supplement the lending power of the IMF. In creating the General Arrangements to Borrow, countries were not prepared to lend passively to the IMF, which they regarded as being dominated by the United States. They therefore forced a procedure “under which they, as lenders, would have the chance to consult and make decisions among themselves upon receiving a proposal from the Managing Director of the IMF”(Solomon 1977, p. 43). The G-10 and WP3 took up this role. 8
The British pound was a major beneficiary of these arrangements. There were ‘Basle credits’ for sterling in 1961, 1964, 1965, and 1966. The BIS was the coordinator. In connection with the 1967 pound devaluation, Solomon (1977, p. 94) remarks that: “In both Washington and Basle (between which the
With the end of the fixed exchange rate system in the 1973, the BIS lost many of its roles: there was no longer a reason for the complex engineering of international transactions among central banks to shore up exchange rate parities. But the structural changes in the international monetary system also opened new challenges and opportunities to the BIS. The large bank losses from unsettled foreign exchange transactions in the wake of the Bankhaus Herstatt failure in 1974 focussed attention on the importance of a framework for international cooperation among bank supervisors, many of whom were the same central bankers attending the BIS monthly meetings. This incident gave the BIS the opportunity to enter the field of international financial regulation. Furthermore, the demise of the Bretton Woods system did not mean the end of international financial crises. On the contrary, the implementation of financial liberalization programs in many nations of the world and the abolition of capital controls and exchange controls exposed the international financial community to the potential of more and bigger crises. Examples include the Mexican debt crisis of 1982, and the currency crises of 1994 in Mexico, 1997 in South East Asia, 1998 in Russia, and 1999 in Brazil. These events sharply redefined the role and strategy of the BIS.
The BIS Today The current activities of the BIS can be divided in three broad categories: international monetary and financial cooperation, agent and trustee, and financial assistance to central banks (BIS, 1999, pp. 151-167). We discuss in reverse order. The BIS holds some of the reserve assets, including gold and currencies, of many central banks. These assets are invested in international bank deposits, securities and government treasury bills. Central banks use them to manage liquidity. As an agent, the BIS handled the private clearing and settlement system of the artificial currency European Currency Unit from 1986 to January 1999, when the European Monetary Union was established.9 The Bank is an agent for some international loan issues as well as the trustee for holding the collateral for some
telephone was in active use) there was discussion of an IMF credit of $1.4 billion plus central bank credits of unspecified maturity of another $1 billion.” 9 Sixty-two banks were members of this clearing union.
international bond issues, notably for Brazil, Peru, and Cote d’Ivoire. Finally, the BIS arranges loans, not only for member countries, but since 1982 also bridge loans to emerging market countries in liquidity difficulties.10 These loans are generally made only where there is an IMF adjustment program and the IMF or the World Bank makes repayments.11 For example, in 1998, the BIS coordinated a $13.28 billion facility for the Banco Central do Brasil, backstopped or guaranteed by 19 central banks with a $1.25 billion parallel facility by the Bank of Japan. In the previous year it provided bridge finance to the Bank of Thailand along with G10 central banks and other Asian and European central banks. In line with its historical roots, international monetary and financial cooperation is a key activity of the BIS. The Bank is a forum for central bankers and the international financial community to discuss and find agreement on “key issues affecting monetary policy and financial stability” (BIS 1999, p. 151). This consultative-cooperative process can be subdivided in three different activities. Under the first activity, the Bank organizes meetings of central bankers and other officials on business cycle and monetary developments affecting financial stability. The most prominent are the monthly meetings of the G-10 central bank Governors of the G10. The output of this activity is on the “nonvisible,” although highly cherished by the members. Under the second activity, the Bank organizes meetings with other international organizations on topics of mutual interest. For example, the BIS participates in the Working Group on International Financial Crises whose objective is to recommend policies for preventing international financial crises and for resolving crises once they occur (BIS 1999, p. 158). Under the third and final activity, the Bank acts as the host and secretariat for various committees on financial regulation. The most prominent of these entities is the Basel Committee on Banking Supervision (BCBS).12 Two other entities are the Committee on the Global Financial System --that 10
The loans are arranged either on the BIS own account or through syndication among other central banks. 11 Apparently, these loans are made only to central banks. 12 Given its importance in standard setting, a few words on the BCBS are in order. The BCBS is distinct from the G-10 central bank Governors. The reason is that the BIS has historically jealously guarded its club of central bankers from outsiders; yet, the move into international bank regulation and bank supervision required opening the door to an expanded representation of government agencies. Operations are very much a result of networking arrangements. Although there is a centralsecretariat supportwithin
replaces the Euro-currency Standing Committee--, and the Committee on Payment and Settlement Systems (See Table 1). All of theses committees are engaged in important aspects of the regulatory environment and participate in the newly formed Financial Stability Forum (FSF). The output of this activity is the promulgation of international banking and financial standards. In the next section, we will discuss in more details the evolution the BIS has undergone since the demise of the Bretton Woods system. This evolution shows a great deal of resilience of the institution and reflects the flexibility accorded to it by a relatively small and homogeneous membership.
V. THE CHANGING NATURE OF POLICY COORDINATION AT THE BIS
As noted, Article 3 of the BIS Statutes states unequivocally that the Bank is “to promote the cooperation of central banks and to provide additional facilities for international financial cooperation…” The terms of reference for cooperation have changed over the almost seventy years history of the institution. In the early years, cooperation meant to sustain and “lubricate” the mechanisms of the gold standard, and after World War II the gold-dollar exchange standard. With the collapse of the Bretton Woods system the Bank progressively shifted focus from international monetary cooperation to international financial regulation and supervision. Many central banks are also bank regulators and supervisors. However, this is far from a one to one relationship. The Federal Reserve shares the bank regulatory field with the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, and state banking departments. Some central banks--such as the Deutsche Bundesbank, the Bank of Japan, and the Banque de France--have a few regulatory responsibilities, the bulk of them residing with other government agencies.13 Some central banks have no
the BIS for this work, it is carried out largely by individuals from the member countries and not by the BIS itself. 13 These regulatory are the Bundesaufsichtsamt fur das Kreditwesen for Germany, the Financial Supervisory Agency for Japan, and the Commission Bancaire for France.
regulatory role, aside perhaps from regulatory issues pertaining to the payments system. The Bank of Canada falls in this category. The Bank of England is another example: in 1998 it was forced to shed its regulatory role to focus solely on central banking. In practice, it is difficult to separate central banking from banking regulation. For example, a central bank that has no regulatory or supervisory responsibilities would still need credit information on financial system participants in order to prevent losses to itself as a counterparty in transactions, or to prevent losses to participants in the payments system. The payments system, because of its relationship to the transmission of systemic risk, is a central concern to central banks. Thus, it is not surprising that central bank governors identified the need to deal with financial regulations as part of their involvement with operational issues. The G-10 central bank Governors set up a Committee on Banking Regulations and Supervisory Practices in 1974 after the failure of Bankhaus Herstatt. In 1975 it became the BCBS. Since then it has held meetings regularly, including those of specialized working groups. At these meetings, central bankers are typically accompanied by officials from those government agencies that are responsible for prudential supervision of banks. As de Swaan notes (1997, p. 2), the BCBS has evolved: Into a rule-making body, whose standards and recommendations are recognized and implemented in legislation on a global scale…[T]he internationalization of the banking industry and the nature of the risks to which banks are exposed made it clear long ago that there was a distinct need for a philosophy of consolidated supervision, calling for international cooperation. The BCBS works with securities regulators, insurance regulators, the “Offshore Group of Banking Supervisors” and others to bring the appropriate expertise to bear on the problem at hand. The Offshore Group includes banking supervisors from offshore financial centers ranging from Aruba, Bahamas, Bahrain, the Cayman Islands to Vanuatu. The BCBS draws from the resources of central banks and bank supervisors of the G-10.14 14
For example, the Task Force on Accounting Issues as of October 1998 was chaired by a Canadian regulator and was constituted of 19 other members representing Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Sweden, Switzerland, the United Kingdom, the United States, the European Union, and the Secretariat of the BCBS. The United States was represented by theBoard
The tasks of the BCBS change regularly. The first task resulted from a mandate from the G10 central bank Governors to consider early warning systems to financial problems such as Bankhaus Herstatt. This led to a design of the methods for international cooperation, how to close gaps in bank supervision among countries, and ways to improve mutual understanding and the quality of bank supervision. Since then, the Basel Committee has touched upon many areas of financial regulation, including •
the supervision of cross border banking;
•
bank capital standards, including updates and enhancements;
•
sound practices in areas such as “OTC Derivatives Settlement Procedures and Counterparty Risk Management”, “Sound Practices for Loan Accounting, Credit Risk Disclosure and Related Matters”, and “Public Disclosure of Market and Credit Risks by Financial Intermediaries;” and
•
the regulation of financial conglomerates in conjunction with the International Organization of Securities Commissions and the International Association of Insurance Supervisors.
Cross-Border Banking
The supervision of cross-border banking is at the heart of the capability of the BIS to exert authority in the banking arena. The initial impetus was given by the Basel “Concordat” of 1975, which tried to establish norms on how supervision of internationally active banks should be shared among countries. It was then expanded as supervisors learned from cross-border banking problems. In 1992, four main principles were established as minimum standards to provide leverage for national regulators to deal with the international activities of banks from less regulated systems, whether from major countries or not, and hence to impose discipline on the entire system:
of Governors of the Federal Reserve, the Federal Reserve Bank of New York, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation.
1. All international banks must be supervised by a home country authority on a consolidated basis; 2. The creation of a cross-border banking establishment should receive the prior consent of both the host country and the home country authority; 3. Home country authorities have the right to gather information from their cross-border banking establishments; and 4. If the host country authority determines that any of these three standards is not being met, it can impose restrictive measures or prohibit the establishment of banking offices.
Principle four, in particular, establishes an entry barrier to a financial market if banks from another country have not met minimum standards. We shall return to this topic in our discussion of the implementation of standards (See Section VII). In 1997, the BCBS, in cooperation with representatives from emerging economies, issued 25 “Core Principles for Effective Banking Supervision” (BIS, 1997) applicable to all countries and not just the G-10. The G-10 central bank Governors and the G-7 finance ministers endorsed the document. The “core principles” cover preconditions for effective supervision, licensing and structure of the banking system, prudential regulation, methods of ongoing supervision, information gathering and use, powers of supervisors and crossborder banking. Eichengreen (1999b, p. 25) praises the principles as a demonstration that it is feasible to set standards in the financial markets, and would use them as part of a comprehensive reform of the IFA.
Capital Requirements
Minimum capital requirements for internationally active banks began with the first Basel Capital Accord in 1988, called the “Accord” (“International Convergence of Capital Measurement and Capital Standards”). The principle underlying the Accord was to link capital requirements to the banks’ credit risk through mandated weights for different categories of bank credit.
The push for the "Accord" came about because of regulatory capital arbitrage and national differences in the definition of bank capital and regulatory enforcement. These differences, in turn, allowed banks in some countries to be much more competitive than banks in other countries. Furthermore, this was seen as a useful prudential step to reduce the risks of the failure of under-capitalized banks as well as to strengthen the financial system from the spread of systemic risk. The 1988 Accord was ultimately adopted by over 100 countries, for their domestic banks as well as for banks involved in international transactions. It was a success for the G-10, despite criticism for the Accord’s crudeness and political bias. The nature of the latter showed in a number of ways. One was the preferential treatment given to government debtors, even if inferior in credit rating to corporate credits. This either reflected the nature of the government representatives to these meetings or represented the dated view that governments are superior credits, at least when borrowing in a currency which they print. The other type of bias was in granting OECD members a zero weight for their country credit risk, as opposed to non-OECD countries having a 100 percent weight. This meant that Turkey would have had a zero weight while Singapore a 100 percent weight. But the 1988 Accord was overly simplistic in other ways. It assigned the same weight for all claims on banks in the OECD area, as opposed to differentiating on the basis of credit criteria. This meant that a Mexican bank would have 20 percent risk weighting as opposed to 100 percent weighting for General Motors or IBM. There is no doubt about the impact of the Accord on financial markets. Shirreff (1999, p. 25) states that the “lack of charge for assets below one year may have encouraged the short-term lending that was the undoing of Mexico in 1995 and of Korea and Indonesia in 1997”. He also notes (p. 22) that: “There is a view that unelected central bankers in Basel should not be empowered to trigger radical changes in capital flows in emerging markets”. The fundamental issue is that the Basel capital rules allocate financial resources among different sectors and different competing projects in an economy; by following them countries are potentially creating distortions in their economies. But distortions should not be assessed in a vacuum. National regulation also creates distortion, which can be smaller or larger than the Basel capital rules.
A 1996 Amendment, implemented in 1998, expanded the 1988 Accord to include market risk in bank trading accounts. In 1999 the Basel Committee introduced a proposal for comment on extending the capital framework and broaden the coverage of risk. The new framework would not only include minimum capital requirements but also a supervisory review process of capital adequacy and the use of market discipline–that is, disclosure and transparency. The new proposals for regulation and supervision are trying to remedy some of the weaknesses in the 1988 Accord. They too have been criticized as being politically influenced. According to Merchant (1999, p. 15), Standard and Poor’s has objected to “…national authorities determin[ing] the [capital] weighting of local currency sovereign debt.” Others find that the proposals do not fundamentally alter the privileged position accorded to sovereign debt relative to corporate debt of different ratings. Others claim that Germany was exercising undue pressure to obtain favorable treatment for commercial mortgages in German banks.15 All of these criticisms reflect the general point that the Basel Committee has made progress towards closing the gap between regulatory capital and economic capital, but has not gone far enough. Even the apparent market friendly decision of linking capital weights to the credit ratings issued by agencies like Standards and Poor’s creates a difference in standards between countries where credit-rating agencies are active (most industrial countries) and countries where this activity is absent.
The Basel Committee on the Regulation of Financial Conglomerates It is clear that more and more financial institutions are becoming part of financial conglomerates selling a wide range of products. In reaction to these developments, the Basel Committee was supplemented in 1987 by the Technical Committee of IOSCO (the International Organization of Securities Commissions), a cooperative body of securities regulators. In 1993, the insurance industry set up IAIS (the International Association of
15
This political pressure is acknowledged by Deloitte & Touche (1999, p. 2): “The Committee developed the Consultative Paper (very rapidly, it should be said, and it would have been quicker still but for a spat about the risk weighting of commercial mortgages) in response to a call by the G7 finance ministers’ for the strengthening of prudential regulation in both industrialized countries and emerging markets.”
Insurance Supervisors). This, in turn, set the stage to consider analytically the risks of financial conglomerates. The expansion of the initial mandate of the BCBS intended to handle two types of issues. One was to properly assess the risks created by financial conglomerates. The second was to understand how separate groups of regulators and supervisors, acting under different legislation and regulatory and supervisory powers, actually regulate conglomerates; that is, were there regulatory gaps? Under the leadership of Gerry Corrigan of the Federal Reserve Bank of New York, in 1993, supervisors from the three financial sectors began work on the regulation of financial conglomerates. In 1995, the Basel Committee and IOSCO were requested by the G-7 Halifax Summit to produce a joint statement on cooperation between banking and securities supervisors. This was followed by the “Joint Forum” of regulators from the three financial sectors, with a mandate to facilitate working arrangements among supervisors and to establish principles of supervision on matters like capital and group exposures. In February 1999, the Joint Forum released its papers on the supervision of conglomerates. This included capital adequacy, fit and proper criteria, and supervisory information sharing. In July 1999, it also released consultation documents on the principles that banking, securities and insurance supervisors ought to follow to ensure good control over intra-group exposures and transactions and risk concentrations. This area is extremely difficult for a number of reasons. One, each regulator follows different laws and regulations. Second, each regulator faces a different political constituency in its home market. Third, differences in accounting standards, capital rules and institutional differences among countries lead to competitive advantages and disadvantages. Finally, those who are adversely affected by the rules exert significant pressure for change.
An Assessment of the Basel Committee Work In Section III above we have argued that international coordination of national regulation and financial standards is a superior strategy to either national regulatory competition or a single supra-national regulatory agency. The political advantage of the coordinated
solution is that it is consistent with the aspirations of many countries not to relinquish complete control of financial regulation to a non-accountable and unresponsive World Financial Authority. There is a natural division of responsibilities in the coordinated solution. While standard setting must be global and, thus, entrusted to an organization like the BIS Group, rule implementation is best left with the national authorities. There is no good alternative to vesting local regulatory and supervisory agencies with the task of enforcing the international standards. This is for two reasons. First, as we have repeatedly mentioned, it is wishful thinking that national authorities may wither away or be superseded by an international agency (see Eichengreen, 1999a, 1999b). But just as importantly, oversight and supervision require intimate knowledge of local institutions, markets, and management, which cannot be delegated to a distant and unaccountable international enforcer. Local enforcement does not mean that the international community is impotent in encouraging proper enforcement. To begin with, the very act of accepting international standards of best practices unleashes the powerful force of millions of economic operators and institutions that have an interest in making sure that these standards are enforced. This activity is spontaneous and uncoordinated and, using the terminology of von Mises, can be likened to a “financial night watchman” (Jordan, 1999). Furthermore, credit-granting international organizations like the IMF and the World Bank can employ a combination of carrots and sticks to ensure proper enforcement. An example of carrot policy has been suggested in the recently published Task Force Report (1999) sponsored by the Council on Foreign Relations. The first of their seven recommendations reads as follows (p. vi): Greater rewards for joining the “good housekeeping club.” The IMF should lend on more favorable terms to countries that take effective steps to reduce their crisis vulnerability and should publish an assessment of these steps so the markets can take note. An example of stick policy would be for the BIS or IMF or the BIS to require a larger amount of sound collateral and charge higher penalty interest rates to countries that, wanting to borrow, have failed to exercise proper enforcement of international standards. More on this in Section VIII.
As we have argued in the Introduction, the BIS Group is moving to center stage in this process. This Group has received an additional boost in 1999 with the establishment of the Financial Stability Forum (FSF). FSF is a coordinating group consisting of senior officials from finance ministries, central banks, and regulatory agencies of the G-7 countries plus Hong Kong, Singapore, Australia, and the Netherlands. Representatives from the IMF, World Bank, OECD, BIS, BCBS, IAIS, IOSCO, the Committee on Global Financial System, and the Committee on Payment and Settlement System are also included. As Andrew Crockett (1999), General Manager of the BIS, puts it: “The broadbased nature of the Forum’s membership should also equip it to deal with the multifaceted nature of financial stability.” A trade-off is apparent between universal membership and efficiency. The risk is that in expanding membership--in particular by bringing representatives not only from central banks but also from finance ministries and regulatory bodies--the BIS would lose flexibility and effectiveness. This risk is more than theoretical. AndrJ Icard (1999), Assistant General Manager of the BIS, describes it very eloquently: The FSF authority has to be accepted worldwide. This will be hard to achieve unless other countries are admitted; this poses the question of the appropriate balance between [representation], which tends to enlargement, and efficiency, which pleads in favor of a restricted grouping. Obviously, the FSF will have to expand again, but this process cannot be very large in addition to the existing 40 participants. Here lies the danger of successful organizations: they risk expanding beyond their optimal size. The BIS is not immune from this risk. Success sows the seeds for failure. Only a vision and an understanding of the underlying processes may stop the push for an ecumenical membership.
VI. IS THE BIS UP TO THE CHALLENGE?
The BIS has evolved over its almost seventy-year history. Is this evolution justified in light of market developments or is the BIS a “puppet” of the important central banks of the world that seek shelter from external scrutiny? Our answer is that, on balance, the BIS has performed and continues to perform a significant role in the market place. The
expectation is that the BIS Group can solidify its position as the reference point for the international regulatory coordination strategy. The challenge for the institution is to resist pressure for enlargement and lose, in the process, much of its comparative advantage.
Strengths of the BIS The strengths of the Bank can be summarized as follows. First, the Bank has reduced the negative externalities in international financial transactions attributable to financial institutions that deal with counterparties from jurisdictions with poor regulation. The failure of the Bank of Credit and Commerce International is a good example of such externalities, and led the Basel Committee to amend its work on the supervision of internationally active banks. It was a response to “market” developments. Second, it is difficult to predict the types of future international financial crises – whether sparked by real, monetary, or banking factors-- to which national central banks and treasuries will be called to respond. Financial history is replete with incidents of inadequate or outright wrong responses by central banks to financial crises. The integration of national capital markets accentuates cross-border spillovers and, hence, increases the value for central banks and financial regulators to coordinate their activities. Bad regulation by financially important countries, in an integrated world capital market, is like a bad apple in a basket of good apples. Can individual financial institutions, under completely decentralized decision making, identify and weed out the bad apple as efficiently as they would with the aid of a coordinator? This is the central question. Asymmetry of information, which is so pervasive in banking, argues strongly for a coordinator and explicit standards. Third, given the uncertainty about the type of shocks that may trigger a financial crisis and the fast pace of financial innovation, the coordinating agency should display flexibility in adjusting the strategy to changed circumstances. The long history of the BIS has shown that this institution can adapt. Adaptation has been made possible by a relatively nimble organization and by a small and a homogeneous membership. Larger organizations, with universal membership and a plethora of objectives, cannot adapt as well. For example, the BIS was very quick to rise to the challenge of meeting regulatory
deficiencies at the global level. It brought together the relevant regulatory bodies and tried to achieve consistency and competitive equity among various sectors. It has not been completely successful, but then complete success may be beyond anyone’s abilities and competence. But to have started this process is in itself a remarkable feat. Fourth and last, the comparative advantage of the BIS is in promulgating financial core principles or minimum financial standards, and convincing financially important countries to adopt them. The BCBS has already produced a list of core principles and is working to revise them. The implementation of the standards, on the other hand, should be left to national regulators who have the authority and the detailed local knowledge for effective enforcement.
Weaknesses of the BIS The BIS has a number of significant weaknesses. The first of these weaknesses is less attributable to the institution than to the IFA architects. Many international financial institutions are competing in the same market (see Table 1). While we support competition among regulators and institutions, this competition is not governed by clear rules of the game. Nor is there a well thought out plan for the mandates of these organizations. Often, these spend of lot energy and resources to find some common ground. Cooperation turns out to be costly and incomplete. For example, the FSF calls for broad participation of international organizations, including the BIS, the IMF, World Bank, OECD, the BCBS, IOSCO, and IAIS. But inclusive memberships arise when there is no clear view of who does what; they are also ineffectual (e.g., the United Nations). A redefinition of jurisdictions and objectives can either be done politically, at the top level and through the medium of a Bretton Woods-type conference, or through open competition. The premises for either solution do not exist at present. The most likely outcome is that the future will give us more international institutions with increasingly overlapping memberships and objectives, together with self-protective measures taken by individual institutions. In response to a lack of an explicit mandate, the BIS created its own after the failure of Bankhaus Herstatt. Management directed the efforts of its committees towards
specific issues –e.g., the disclosure of derivatives activities and foreign exchange netting— rather than pose broader strategic regulatory questions. The result was an excessive allocation of resources to bank capital management and an under-allocation to liquidity management. The 1988 Capital Accord was motivated, to a large extent, by the desire to create a level playing field. This objective has proved elusive, as Goldstein and Turner (1996, page 27) note that: “banks in most of the emerging economies … do not appear to have risk-based capital ratios significantly higher than those in the larger industrial countries – despite the higher-risk environment they face.” But should the level-playing field be an overriding objective? Financial integration does not mean that all assets must be identical. If that were to occur, there would no value in diversification. A more operational definition of financial integration is that there are no impediments to portfolio diversification (von Furstenberg and Fratianni, 1995, pp. 72-76). Differences in credit risks will be reflected in prices and in assets being imperfectly substitutable and should pose no significant challenge to institutions and individuals that have mastered the principle of portfolio diversification. Finally, financial standards are not stand-alone products. Their effectiveness depends on the truth-value of the information provided by the banks. Given that banks and financial institutions have an inherent informational advantage with respect to, not only the public at large, but also to regulators, faith in the numbers is critical for the standards to succeed. To this topic we now turn our attention.
VII. THE IMPLEMENTATION OF STANDARDS
We have argued that a coordinated strategy is superior to either national regulatory competition or to an all-powerful World Financial Authority. A coordinated strategy involves the promulgation of minimum standards. These standards will have to be voluntarily adopted by countries and will have to be enforced locally. While there is no better alternative, local implementation is the Achilles’ heel of the scheme.
One possible solution to the implementation problem would require incentivecompatible contracts between the BIS Group and national regulators to ensure that the interests of the latter coincide with the objectives of the former. The reason for incentivecompatible contracts is that the auditing techniques are imperfect and give rise to multitier incentives for misrepresentation (a euphemism for lying). Bank management misrepresents information to national regulators because it wants to collectivize eventual bank losses. Bank regulators misrepresent information to the legislative branch because it wants to capture parts of the rents of the collectivization (Laffont and Tirole, 1991; Hauswald and Senbet, 1999). In an international context, there would be a third layer of misrepresentation: from the national regulators to the BIS Group and the ILOL agency, motivated by the desire of the national banking industry and national regulator to collectivize (at the world level) the eventual losses of national bank failures, such as through the IMF. The theory of incentive-compatible contracts wants to solve the problem of regulation by making it a self-enforcing mechanism. While we are strongly in sympathy with this literature, we also find it impractical at this stage. To fix the problem at the world level, we would have to implement a myriad of incentive-compatible contracts and we would have to endow the BIS Group with a budget sufficient to write incentivecompatible contracts with several hundred national regulators. The degree of interference with national body politics would be such that people would raise the same objections against the coordinated solution that we have raised against the World Financial Authority. The alternative to incentive-compatible contracts is to find an implementation procedure that does not rely on the spontaneous implementation of the financial standards by all countries. We have serious doubts that an environment of total or near total confidence in one another exists, let alone that it would work. The current BIS system works for G-10 countries for two reasons. It works because the central bank governors and senior regulators meet regularly, at least once a month. The meetings spread essential knowledge, including those who cheat, and build confidence in each other’s regulatory systems. The G-10 is small, homogeneous, and is a repository of deep knowledge of financial markets and business practices, including accounting standards. Equally
important, the G-10 accounts for a very large share of the international financial transactions. The extent of the asymmetry is such that the G-10 regulators can induce imitation in other countries’ regulators, through the force of competition. In essence, the G-10 countries would act as industry leaders and implement best business practices. The rest of the industry would have the choice of either responding in kind or to find an alternative. Those who respond in kind would have the privilege to do business with industry leaders; the others would have to create a network of their own. Let us see how such a system may actually work. Take two important members of the G-10, the United States and the United Kingdom. These two countries have the largest financial markets in the world and are leading players in the BIS Group. More importantly, a vast number of internationally active banks reside either in the United Kingdom and/or in the United States. The two countries impose higher standards than those mandated by the BIS; these standards represent the industry’s best business practices. A large number of internationally active banks voluntarily accept the U.K. and U.S. standards.16 The U.S. and U.K. regulators routinely assess home country regulation, accounting standards as well as central bank and payments systems for all inbound banks. They also make a determination as to how much to rely upon foreign supervision. If doubts exist on the latter, domestic supervision takes over.
What would happen to foreign banks that did
not to qualify, on a first cut, for access to the high-regulation markets of the United States and the United Kingdom? These banks would have the following four alternatives: •
they could apply for a banking subsidiary charter in the United States or the United Kingdom and, consequently, elect to adopt the standards and oversight rules of the host regulator.
•
they could seek a certification of BIS-inspired international financial and accounting standards by an internationally recognized accounting firm. The certification would be tantamount to a financial passport for cross-border financial transactions. The financial passport, however, may not be valid for the more regulated U.S. or U.K. banking and financial markets.
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•
they could move their business to host states with lower regulatory standards than the BIS-inspired standards. These banks would have a limited geographical reach in their cross-border transactions. Furthermore, they would be located in sub-standard regulatory countries that would not be eligible for the international lender of last resort facility (see below).
•
they could refrain from international banking and financial activity.
In sum, internationally active banks have the choice to do business in high, acceptable, or low regulation markets. The high-regulation countries implement best business practices because they desire to maintain a stellar reputation for sound banking practices. They also attract a large share of the world’s internationally active banks. These countries are the industry’s leaders and raise the bar for the system as a whole. Through competitive pressure, some countries would emulate the industry’s leaders; others would adopt the BIS-inspired standards, which are minimum standards. The adoption of the BIS-inspired standards would be a sine qua non to do business with high-regulation countries and to qualify for ILOL services. Finally, other countries would opt for a low-regulation and a higher risk strategy. International active banks would have a choice to locate in one of the three areas, and competition for regulation would be preserved. The transmission of risk from one area to the area would be curtailed by the application of the Basel Concordat principles (see Section V). Host country regulators have the power to disconnect the operations of internationally active banks operating in their territories. Not only would low-regulation countries be unable to deal with higher regulation countries, but they would also lose access to the ILOL facility.
VIII. THE ILOL FACILITY
Contagion places at risk well-behaving countries, that is countries that adhere to good macroeconomic policies and financial standards. These countries deserve access to liquidity from an international organization to deflect the consequences of contagion.
Countries cannot qualify for ILOL if they do not adhere to international standards. In this section we sketch a few principles of the ILOL facility. Liquidity and the management of liquidity crises, surprisingly, have received little or no attention by either the BIS or the collateral BCBS. Yet, the provision of liquidity during times of financial distress is just as important as the establishment of good regulatory norms and sound supervisory practices. Liquidity is probably a far greater issue for financial safety and soundness than capital, and yet receives almost no attention. In a domestic market, typically the central bank is charged with the task of being a lender of last resort. The Federal Reserve System relied on this provision to calm the financial markets in the wake of the 1987 sharp stock market decline. In the international arena there is no comparable institution. Meltzer (1999) and Calomiris and Meltzer (1999) have argued for the creation of an ILOL facility that would charge penalty rates - that is interest rates above the prevailing money market interest rates - against marketable collateral. The collateral requirement would induce national central banks to hold a "precautionary" stock of internationally traded assets and, consequently, reduce the likelihood of a liquidity crisis. National central banks, in turn, would extend loans denominated in key-currencies to banks under liquidity stress. Our analysis of the BIS and its long history as a "club" of central banks suggest that the Bank would have a comparative advantage in playing the role of ILOL coordinator. Let us explain how this may work in practice. In an international liquidity crisis, national central banks run out of short-term assets denominated in the key currencies of the world. There are a handful of such currencies: in descending order the U.S. dollar, the German mark, the Japanese yen, the British pound, the Swiss franc, and the French franc. With the creation of the European Monetary Union, the number of key currencies will be further reduced. And so will the number of central banks that will be potentially called to provide ILOL services: in descending order the Federal Reserve System, the European Central Bank,17 the Bank of
More precisely it is the European System of Central Banks, rather than the European Central Bank, that would be asked to provide ILOL. The Maastricht Treaty does not authorize the European Central Bank to act as a lender of last resort.
Japan, the Bank of England, and the Swiss National Bank. The BIS would act as a coordinator of the few ILOL providers desired by the market. The Bank has a long experience in dealing with central banks and in coordinating their financial activities. It holds some of the central banks’ reserve assets, including gold and currencies, and invests them in international bank deposits, securities and government treasury bills. During the Bretton Woods regime the BIS routinely arranged and coordinated multi-party swap agreements. The BIS is an agent for some international loan issues and a collateral trustee for some international bond issues. The BIS also coordinates international loans to national central banks. Finally and most importantly, the BIS is much more agile and less political than the International Monetary Fund. As an ILOL coordinator, the BIS would act as lead manager for any international loan facility. The responsibilities would include due diligence, choice of applicable law, setting an interest rate to clear the market on a risk-adjusted basis, as well as acting as agent for the group of lending institutions coordinating the credit conditions of the loan, loan covenants, and collateral where used. The agent would determine what appropriate covenants were necessary to secure the assets, and monitor conditions applying to the loan, such as monitoring any collateral, and the actions of the borrower to ensure agreement and compliance with loan covenants. Examples of such covenants would be that the liquidity loan be ranked ahead of other types of indebtedness and that the courts of the United Kingdom or the State of New York, the most commonly used in these transactions, have legal standing. As an interest-rate setter, the BIS would ask the five ILOL providers whether they would be willing to satisfy the loan request at, say, LIBOR (London Interbank Borrowing Rate) plus 2 percentage points. If that request is not fully met at that rate, the penalty rate would move up, say, to LIBOR plus 3, and so on. Collateral is used infrequently. However examples do exist. The United States financing for Mexico in 1995 required a guarantee based upon oil revenues. It is critical that the liquidity loan be offered at penalty rates; otherwise, the ILOL providers would encourage moral hazard and repeat the mistakes of the past. To ensure this, the BIS and the ILOL providers could invite private commercial banks to bid on part of the liquidity loan. Should the private quota go unfilled or partially filled, one would
infer that the loan had been subsidized. To signal that the liquidity loan is not mispriced and yet allow a rapid response, the private quota could be set quite low, say 5 to 10 per cent of the total loan. Under the proposed plan, the ILOL providers would not have to take a formal vote to extend a liquidity loan. They would vote with their feet, or better with their pocket books. An unfilled request would signify either significant mispricing of the loan or insufficient guarantees, loan covenants, collateral or a combination of reasons inhibiting lenders. An unfilled private quota would signify the presence of a subsidy in the loan. In sum, the proposal is market friendly. Such a proposal would not find favor with many sovereign borrowers who are used to subsidy rates and political influence to achieve the financing they desire. However this is not a stable long term solution for them, nor is it an economic use of scarce finance resources.
IX. CONCLUSIONS Recent and past history records numerous and a wide variety of international financial crises. These may be the necessary price to pay for a liberal order. Financial suppression at home and controls on international capital flows could prevent such crises, but we would lose the tremendous benefits of a competitive and innovative financial system. In today’s liberal environment the BIS Group can play a valid role in reducing and managing crises. Its nimble membership and organization gives her a comparative advantage relative to universal international financial organizations burdened with a plethora of objectives. We have argued that a coordinated strategy to international regulation is superior to either national regulation or to an all-powerful World Financial Authority. A coordinated strategy involves setting minimum standards, through the auspices of the BIS Group. Banking and financial standards are the core business of today’s BIS. Implementation of these standards is and should be left to local regulatory and supervisory authorities. This is for two reasons. First, it is wishful thinking that national authorities may wither away or be superseded by an all-powerful international agency. But just as importantly, oversight and supervision are hands-on affairs that require intimate knowledge of local institutions and
management, which cannot be delegated to a distant and unaccountable international enforcer. Implementation is the Achilles’ heel of voluntary standards. Our recommendation is to rely on a combination of competition and dominant country position. A small group of countries implements financial standards exceeding BIS-inspired standards. These countries have high regulatory reputation and attract many internationally active banks. They can use their dominant position to induce other countries to adopt the BIS minimum standards. In fact, the Basel Concordat gives host country regulators the prerogative to deny access into their domestic markets to poorly regulated institutions from foreign countries. The final carrot in the implementation scheme is that adoption of the standards is one of the conditions for the country to qualify for the ILOL facility. Our view is that the BIS is better placed than the IMF in handling the ILOL facility. There is a handful of key currencies and key central banks in the world. Given its historical role as a central bank club, the BIS could easily coordinate the lending by key central banks to liquidity strapped central banks. This type of lending would require sound and sufficient collateral and penalty interest rates. As part of the carrots and sticks system, the BIS could offer favorable lending of last resort terms to those countries that, having met macroeconomic fundamentals, have adopted and are enforcing regulatory standards.
LIST OF ABBREVIATIONS
BCBS
Basel Committee on Banking Supervision
BIS
Bank for International Settlements
EMS
European Monetary System
EU
European Union
FSF
Financial Stability Forum
G-5
Group of Five (USA, Japan, Germany, France, and the United Kingdom)
G-7
Group of Seven (G-5 plus Canada and Italy)
G-10
Group of Ten (G-7 plus Belgium, Netherlands, Sweden, and Switzerland as an observer)
IAIS
International Association of Insurance Supervisors
IFA
International Financial Architecture
IMF
International Monetary Fund
IASC
International Accounting Standards Committee
IOSCO
International Organization of Securities Commissions
OECD
Organization for Economic Cooperation and Development
WP3
Working Party Three of the OECD
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Table 1 Players in the International Financial Architecture18 Institution and Group International Monetary Fund • •
Linkage/Place in System Bretton Woods Institution
Numerous Committees Many joint undertakings with other international financial institutions
World Bank Group
Bretton Woods Institution
Role Short and medium-term lending Surveillance Monitoring Standards for data Other standards, e.g. fiscal transparency Development assistance and long-term lending
•
International Bank for Reconstruction and Development • International Finance Corporation • International Development Association • Multilateral Investment Guaranty Agency • International Center for Settlement of Investment Disputes Bank for International Settlements BIS Committees • Basel Committee on Banking Supervision • Committee on the Global Financial System • Committee on Payment and Settlement Systems • Expert Committees on specific issues
Private sector financing Technical assistance
Service provider to central banks and bank regulators and supervisors
Forum for consultation and cooperation in monetary policy and bank regulation and supervision Capital adequacy requirements for banks Standard setting for banks and financial institutions
BIS Managed • G10 Central bank Governors meetings • Joint Forum of Banking, Securities and Insurance Supervisors • Financial Stability Forum
6JKUKUCJKIJN[CIITGICVGFUWOOCT[QHCNCTIGPWODGTQHKPVGTPCVKQPCNQTICPK\CVKQPUCPFENWDUVJCV
FGCNYKVJVJGYQTNFQHKPVGTPCVKQPCNHKPCPEG4GCNKV[KUOQTGEQORNGZDQVJKPVGTOUQHPWODGTUQH DQFKGUCPFEQOOKVVGGUCPFKPVGTEQPPGEVKQPU
BIS Linkages • International Organization of Securities Commissions • International Association of Insurance Supervisors
International Organization of Securities Commissions
International Association of Insurance Supervisors
Financial Stability Forum
Multilateral Development Banks other than World Bank Group
Evolved to present form in 1990 from predecessor organization Created in 1994 to bring insurance into international supervisory net Created in 1999. Has wide and expanding membership
Groups international securities regulators Attempts to set standards Groups international insurance regulators Attempting to set standards Assessment of vulnerabilities of the international financial system
Coordination of international financial standards Regional development Long-term loans and development assistance
• • • •
African Development Bank Asian Development Bank Inter-American Development Bank European Bank for Reconstruction and Development Organization for Economic Cooperation and Development •
Working Party Three
Evolved from Marshall Plan and Postwar European Intergovernmental Organization
Forum for consultation and cooperation in economic policy Standard setting in corporate governance
Paris Club
Established in 1950s to deal with Argentine debt
Informal discussions for settlement of official loans to countries
World Trade Organization
Successor to General Agreement on Tariffs and Trade
Has a mandate in regulating financial services
European Union
15 European countries and expanding
11 countries have a common monetary policy
• •
European Central Bank European Investment Bank
Group of Five
Financial integration and standard setting through Directives which are passed into law by each member state
Began in 1973. Includes United States, Japan, Germany, France and the United Kingdom
Group of Seven
G5 plus Italy and Canada
Group of Ten
G7 plus Belgium, Netherlands, Sweden and Switzerland as an observer. Started in 1960s to deal with IMF lending. G7 plus emerging market countries. Draws on IMF, World Bank and BIS for secretariat
Group of Twenty
Aid regional lending Originally formed to discuss international monetary reform Today a forum for intergovernmental consultations Consultative and cooperative forum. Covers a wide range of economic and political issues. An outgrowth of OECD Working Party Three Cooperation among central bankers and finance Ministers Cooperation among central bankers and finance Ministers
Other Groups • • • •
Group of Twenty Two Group of Twenty Four Group of Twenty Seven Group of Thirty Three
Group of Thirty
Bilateral Agreements among central banks and financial Regulators and Supervisors19
Initial motivation was to involve emerging market economies. Current motivation has changed. For example, G-22 defines itself as “systemically significant economies” Private sector
Ad-hoc arrangements originated from specific needs on international financial coordination. Implemented by MOUs – memoranda of understanding.
Consultation for a
Does research and provides recommendations on international financial system and standards Issues cover: information sharing money laundering insider trading investigations
19
The United Kingdom Financial Services Authority, for example, has over 100 MOUs with other governments and regulators.
Table 2 Cross-Border Transactions in Bonds and Equities for Six Countries percentage of GDP Countries U.S.A. Japan Germany France Italy Canada
1975 4 2 5 n.a. 1 3
1980 9 8 7 5 1 9
1985 35 62 33 21 4 27
1990 89 119 57 54 27 65
1995 135 65 172 187 253 187
1998 230 91 334 415 640 331
Source: Bank for International Settlements (1999, Annual Report, p. 118).
