CEPA News - Spring 1999

Butcher shops and banks may both sell tainted products. That is why both are subject to public inspection and controls. The difference is that the butcher can only poison his customers, while the banker's wares can be based on non-performing assets anywhere in the world, and can damage the economic health of us all. This is why financial regulation is necessary for the economic health of the nation. The regulator must detect systemic risks arising from a position that an individual firm - say the Long Term Capital Management hedge fund - cannot cover. Thanks to good surveillance and a timely injection of liquidity, LTCM's uncovered debts will not bring down Wall Street, although the fund's erstwhile principals will have to live with their collapsed personal fortunes for quite some time. Effective regulation stemmed contagion.

The surveillance, regulatory, and intervention capabilities on view in the case of LTCM do not grow on trees. The development of liberal financial markets in national economies, including the 19th century USA, was accompanied by exactly the same sort of volatility and contagion currently afflicting the economies of Asia and Latin America. The response was the establishment of national banking and securities regulators, deposit insurance, and lenders of last resort. The creation of these authorities permitted the growth of liberal markets, which would have been impossible without them.

The current global situation closely resembles that of individual industrialized economies in the past. Existing international agencies are not up to the task of regulating the system. The IMF and World Bank were set up 50 years ago to handle balance of payments and development problems worldwide. They are not the right organizations to deal with today's capital markets. Fortunately, there is an organization that can do the job. It is the Bank for International Settlements based in Basle.

The BIS should be transformed into a World Financial Authority, with major new powers to establish best practice financial regulation and risk management throughout international financial markets. Its mandate should be expanded by giving it new powers and responsibilities beyond its present tasks of simply setting capital standards for banks and co-ordinating international regulation in investment and insurance markets.

The WFA is needed because three decades of international financial liberalization have removed almost all distinctions between national and international capital markets. If liberal finance is to thrive, the same regulatory tasks required in national markets are now needed internationally. That is why the BIS pioneered international financial regulation with the formation of the Committee on Bank Supervision and Regulation in 1975. It was that Committee which formulated the capital adequacy requirements for banks in the 1980s which all 13 then BIS members agreed to observe, and to keep out of their markets foreign banks not adhering to the requirements. The result was that more countries voluntarily signed on to BIS standards in order to achieve market credibility.

Recent events have demonstrated beyond all reasonable doubt that this regulatory structure is not adequate. First, no link has been forged between effective regulation and "bail-outs", a vital precondition for the effective minimization of moral hazard. Second, surveillance powers are (as we all have seen) inadequate. Third, capital requirements and best-practice risk management techniques need to be generalized from banks across the now seamless financial services industry.

If there had been a WFA to enforce best-practice regulatory standards, backed by high-profile surveillance, then some of the horrors revealed in the Asian collapse would have been picked up much earlier (many of them were in fact flagged by the BIS, but its warnings were ignored).

The WFA could also monitor and mediate the imposition of capital controls by national governments. At the moment, a rash of new controls is spreading, and the end of the attack on liberal markets is not yet in sight. By negotiating the need for temporary measures, and adjudicating disputes, the WFA could prevent the attack escalating into a beggar-my-neighbor disaster.

National regulators are necessary to maintain efficient national capital markets. A World Financial Authority is necessary for the survival of an efficient liberal international regime.

John Eatwell is President of Queens' College at Cambridge University. Lance Taylor is CEPA's Director and the Arnhold Professor of International Cooperation and Development. Both are the Principal Investigators of CEPA's project on International Capital Markets and the Future of Economic Policy, sponsored by the Ford Foundation.

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