You have to laugh a little about this financial crisis. It stops you from weeping. Prime Minister Manmohan Singh and RBI Governor Duvvuri Subbarao will be heading for Was-hington on November 15 for a meeting of G-20 leaders, originally proposed by French President Sarkozy and hosted by the outgoing US President, George W Bush. The ?G-20? was formed after the Asian Financial Crisis of 1997-98. The G-7, which came together as a response to Opec in 1973 were happy to dominate global economic governance long after it was justified by their economic power, until the Asian crisis, when it looked like they might have to pick up the tab for a rescue of the global economy.
Possibly proving that the key problem is that politicians try to avoid counting, G-20 actually has 19 member countries, though to be fair, the EU is also a member in its own right in addition to four of its members, also being members of G-20. The 19 member countries of G-20 are the G-7 group of advanced economies: the US, Japan, Germany, Britain, France, Italy and Canada; the four biggest emerging economies: India, China, Brazil, and Russia; and eight other, significant economies: Mexico, Indonesia, South Korea, South Africa, Australia, Argentina, Saudi Arabia, and Turkey.
The Americans are a little shell-shocked at the moment. Now that the US government has partly nationalised the major icons of America?s financial sector, one begins to wonder who won the Cold War? And if Republicans practicing socialism was not bad enough for American sensibilities, it seems that on November 4, southern American states allowed blacks to vote for the first time. They had to queue up for five hours, but still. In this topsy-turvy world and with a lame duck President that no one wants to be seen agreeing with, the US will be a host that is noticeable by its absence. The Europeans will take the lead. Those who rejoice at every loss of American power may soon regret this.
In the domestic context, the Europeans are spending money as if it is going out of fashion. The bill for this crisis to US tax payers so far is around $1 trillion. European governments have committed $2 trillion. You can imagine European taxpayers are not very pleased about this. They consider the problem to be due to an unholy combination of unscrupulous American mortgage brokers selling subprime mortgages to Americans who could not afford them and American locusts?otherwise known as hedge funds. Europeans are bitter.
The agenda that has just come out of a pre-G-20-summit of European leaders is: to regulate everywhere, harmonise everywhere, regulate more, such as bankers pay, strengthen disclosure rules and boost the surveillance role of the IMF.
As with most crises, consensus quickly forms around a set of ideas that few could disagree with, but are often not related to what caused the crisis in the first place. Its not more regulation we need, but better regulation. Current regulatory practices failed. More of the same regulation spread further afield would generate equally severe crises more regularly. Market discipline through transparency and disclosure failed. More monitoring and disclosure would unlikely have succeeded. There were no shortage of sector reports fretting about the growth of the credit derivatives market in the two years prior to the crisis and we have seen how harmonisation around rules on transparent pricing, such as mark-to-market accounting, can have perverse effects in a crisis. I also doubt that Asia would agree to an increased role by the IMF, given it?s fatally flawed advice during the Asian crisis and Asia?s under-representation on its Board.
What we need to see out of the G-20 meeting on November 15 is narrower than Europe?s agenda, but also more focused on the real problems at hand. We need an agreement to reorient regulation towards systemic risks and away from micro-managing banks. The key sources of systemic risk are the economic cycle and leverage. Consequently, capital charges that the banks have to set aside for loans must be two things: (1) time varying?rising in the boom and falling in the consequent slump; and (2) sensitive not just to the riskiness of assets, but how they are funded and in particular with what degree of leverage. And leverage should be the new boundary of who we regulate and who we do not, not whether the legal entity is a bank or hedge fund.
Regulation should strike hardest on those who are leveraged the most using short-term funding and least on those who are unleveraged and have long-term funding of assets. Once regulation forces banks to set aside sufficient capital against systemic risks, in a way that cuts through the markets? constant optimism during a boom and pessimism during a slump, the opportunities for egregious pay deals would be less. This seems to be the right way. The risk is that we end up with the opposite: government?s setting pay and the market determining the amount of capital banks should set aside.
?The author is chairman of London-based Intelligence Capital, governor of the London School of Economics and emeritus professor of Gresham College in the UK